In April 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act, which helps startup companies raise capital by reducing disclosure requirements for Initial Public Offerings made by “emerging growth” companies (annual revenues less than $1 billion). The act includes a “crowdfunding” provision that allows companies to sell up to $1 million of stock each year and have up to 2,000 shareholders without registering with the U.S. Securities and Exchange Commission (SEC), provided most of those shareholders are investing less than 10 percent of their net worth in the company.
Because startups are naturally risky, with a high probability of failure and a small probability of dramatic success, their stocks’ payoffs will look like a lottery. While relaxing disclosure requirements should reduce the costs of raising funds, evaluating this type of investment is difficult. Will there be sufficient information for investors to assess the company’s value?
To investigate how investors value stocks with lottery-like payoffs, my colleague Bjørn Eraker and I collected a sample of returns on U.S. Over-The-Counter stocks from January 2000 through December 2008. These stocks underperformed the market by more than one percent per month, excluding transaction costs, and two percent per month, including transaction costs.
Although many of the OTC stocks become worthless over our sample period (about 25 percent of the stocks lost 99 percent of their initial value), a few had large positive returns that were much higher than those on the stocks in the Center for Research on Security Prices database.
One possible explanation for the negative average returns on OTC stocks is that investors are systematically fooled. Indeed, the loose disclosure requirements make OTC stocks a playground for fraudsters. Popular press, books, and movies, including The Wolf of Wall Street, depict massive frauds where investors are lured into purchasing worthless OTC stock.
Another explanation is the difficulties in shorting OTC stocks, because some brokerages simply do not allow short sales, and those who do allow it impose constraints. It is plausible that constraints on short sales create an environment in which only the most optimistic investors trade.
A third explanation comes from laboratory experiments, which have shown that people are drawn to lottery-like gambles. It is not clear from these experiments whether the results reflect an inherent preference for this type of payoff, or whether people tend to have difficulty assessing the probabilities of extreme positive events.
Our results provide evidence that investors overestimate positive outcomes. Why?
We analyzed the returns on two subsets of OTC stocks: those that previously traded on a major U.S. exchange (“delisted”), and those that did not (“native”). Average returns were much higher for the delisted stocks than for the native stocks, suggesting that the negative average return for OTC stocks (mostly limited to native stocks), does not reflect investors’ inherent preference for lottery-like payoffs but rather an inability to accurately assess probabilities.
If investors focus on a subset of outcomes when assessing probabilities, then stocks with limited information become an ideal vehicle for fraud, a clear concern for regulators, given the expanded ability to finance unproven investments through “crowdfunding.”
Of course, it is also possible that investors get something beyond monetary payoffs from the investment process. They may simply enjoy researching a company with a new and untested idea, making a judgment as to whether it will be successful and waiting to see if the bet pays off.