Lottery-like payoffs in stock returns: the MAX effect in Sri Lanka

Purpose Literature shows that individual investors prefer lottery-type stocks, which exhibit a low probability of extreme positive daily returns, diverging from rational investor behavior. The MAX effect, an anomalous return pattern, indicates that stocks with extreme positive daily returns underperform in the following month. Although well-documented globally, research in developing markets, particularly South Asia, is limited. This study examines the MAX effect in Sri Lanka and its prevalence among small stocks predominantly traded by retail investors. Design/methodology/approach Using data from January 1991 to December 2021, we investigate the MAX effect in Sri Lanka. We first analyze tercile portfolios sorted by maximum daily returns and then, at the firm level, regress monthly returns on the previous month’s maximum daily returns, cross-sectional return predictors, idiosyncratic volatility and skewness using Fama and MacBeth (1973) regressions. A sub-period analysis further clarifies the MAX effect. Findings We observe that the MAX effect persists throughout the entire sample period as well as in sub-periods. These findings suggest the presence of poorly diversified individual investors in Sri Lanka who are drawn to lottery-like payoffs. As expected, we find that the MAX effect is more pronounced among small-cap stocks in Sri Lanka. Originality/value Our study uniquely examines the MAX effect from a frontier market perspective using the Sri Lankan stock market while revealing how less-diversified individual investors respond to lottery-like payoffs.