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Skewness, Individual investor preference, and the Cross-Section of Stock Returns

We propose a novel perspective on testing the negative relation between skewness/lottery-like features and stock returns in the cross-section. This perspective is deeply rooted in individual investor trading behavior. We construct a composite index to capture individual investor preference on stocks and find a monotonically increasing return predictability of skewness/lottery-like features with the index. Our findings suggest that it is individual investors who pay a price in exchange for a small probability of winning a large payoff, thus leading to the negative relation between skewness and return. Our results are robust to various skewness and MAX measures.