Gambling on the Stock Market: The Case of Bankrupt Companies

Abstract

Bankrupt firms’ stock displays unique lottery-like characteristics: for only a few cents per stock one can engage in an investment strategy that offers a low probability of huge future reward, and a very high probability of a small loss. Kumar (2009 a) shows that this type of stock is likely to be attractive to large numbers of relatively less sophisticated individual investors. Using a sample of 351 firms filing for Chapter 11 bankruptcy reorganization and that continue trading on a major stock exchange we confirm that individual investors like to trade in such lottery-like stocks. To be precise, individual investors own, on average, 90% of the stock of firms undergoing Chapter 11 reorganization. More importantly, we explore the market pricing implications of gambling-motivated trading. We find a strong, negative, and statistically significant post-bankruptcy drift of at least -28% over the following year, which is robust to a range of alternative measurement approaches, and is distinct from other known market-pricing anomalies. When investigating the potential role of arbitrageurs in the market for bankrupt firms we find that implementation costs and risk are very high. As such, sophisticated investors will likely have a hard time if they try to exploit the mispricing of bankrupt firms we uncover.

Keywords: bankruptcy, lottery stocks, limits to arbitrage, retail investors, institutional investors, event study

JEL Classification: G14, G33