Distracted by skewness: gambling-driven trading, distress risk and the amplifying role of valuation uncertainty

Purpose This study examines how skewness-seeking behaviour drives the financial distress anomaly in the UK stock market. It also investigates the amplifying role of valuation uncertainty. Design/methodology/approach The analysis covers a sample of 4,514 stocks listed at London Stock Exchange, spanning the period from 1998 to 2021. To examine the hypothesized relationships, both portfolio sorting and Fama–MacBeth regressions are employed. Findings Consistent with the distress anomaly, firms with a high probability of default consistently underperform, particularly when their returns exhibit lottery-like characteristics. While such stocks may appeal to investors seeking extreme payoffs, they generate persistently low average returns, highlighting a disconnect between perceived potential and realized performance. The analysis further demonstrates that valuation uncertainty amplifies this effect. Specifically, the interaction between financial distress, skewness-seeking behaviour and valuation uncertainty exerts a significantly negative impact on future returns. Practical implications The results offer important implications for investors, policymakers and risk managers by illustrating how cognitive biases and uncertainty jointly undermine market efficiency. For example, investors could apply the reported findings to build a profitable investment strategy. For policymakers, it is recommended to promote financial literacy to help mitigate the harmful effects of investor biases on the market informational role. Originality/value The study contributes to the literature by documenting novel evidence on the mispricing of financial distress in the UK market. Furthermore, to the best of our knowledge, this is the only study that links the mispricing of financial distress to investor-biased demand for positively skewed payoffs and to the obscuring effect of valuation difficulties.