Stock loan lotteries and individual investor performance

Individual investors trade excessively, sell winners too soon, and own stocks with lottery features and low expected returns. I propose and model a financial innovation, called stock loan lotteries, that improves individual investor performance. An investor signs a contract with an exchange promising to hold his shares of stock for multiple periods. The exchange operates a stock loan marketplace. Instead of paying each investor the lending fees on his individual shares, the exchange periodically holds a lottery for the entire pool of lending fees. I extend the Barberis and Xiong (2009) two-period model of realization utility to include stock loan lotteries. Investors demand high fixed stock loan fees to hold shares for two periods. Because prospect theory investors value low probability payoffs, they demand significantly lower fees denominated in stock loan lottery tickets. Structuring lending fees as lottery tickets can reduce the investor’s required risky-asset return by at least 2-3%. Stock loan lotteries provide investors with greater expected utility and greater expected wealth. Stock loan lotteries provide the largest benefits to the poorest investors, who typically exhibit the strongest lottery preferences. Introducing trading costs, leverage constraints, and taxes to the model enhances the benefits of stock loan lotteries. I propose a mechanism for exchanges to structure stock loan lottery tickets as derivative securities.