Stocks as Lottery Tickets

When you purchase a lottery ticket you pay a small price for the possibility of a large gain. Gerald P. Dwyer Jr. and Cora Barnhart in Returns to Investors in Stocks in New Industries surmise that investors are doing the same when they purchase stock in new untested companies. This may be especially relevant when the firm’s product might generate network effects. Network economies exist when the productivity of a product is positively related to how many consumers purchase it. Based on their empirical analysis of selected industries they conclude the following:

Adjusted for risk, expected returns are not particularly high for firms in new industries.

Our evidence is consistent with new industries having distributions of payoffs across firms that are highly skewed. In this sense, new industries are similar to lotteries. As is well known though, this can be quite consistent with a log-normal distribution and our data across firms generally are consistent with a log-normal distribution of the cumulative values across firms.

Our evidence uniformly indicates that the expected return to owners of traded stock in new industries is positive and substantial. This is consistent with a supposition that investors receive expected returns that can be interpreted as compensation for the risk they bear. We do not address whether that compensation is consistent with a model of market equilibrium at the level of individual firms.