Barber and Odean (2000) find evidence that individual investors trade frequently and earn low average returns relative to a passive strategy. Investors who trade the most frequently earn the lowest returns. Odean (1998) shows that poor performance by individual investors is largely due to the disposition effect, the tendency to sell positions to realize a gain. Stock loan lotteries incentivize individual investors to trade less frequently. An individual investor signs a contract with a centralized 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.
Barberis and Xiong (2009) develop and solve a two-period model of realization utility. Investors have Tversky and Kahneman (1992) cumulative prospect theory preferences over realized gains and losses. Because prospect theory utility is concave over gains, investors prefer to liquidate part of their holdings after the first period following a gain, generating a disposition effect. This paper compares investor outcomes in the Barberis and Xiong (2009) model to two alternatives. First, investors must hold their position for two periods and receive a fixed stock loan fee. Second, investors must hold their position for two periods and receive stock loan lottery tickets.
In frictionless markets, investors demand a high fixed stock loan fee as compensation to hold their position for two periods. Because Tversky and Kahneman (1992) preferences overweight low probability events, investors demand significantly lower compensation denominated in stock loan lottery tickets. For a wide range of feasible parameter values, introducing stock loan lotteries provides unconditional welfare gains in the form of increased expected utility and expected wealth. Stock loan lotteries have other appealing features. They are an effective regressive instrument in that the poorest investors experience the greatest improvements in utility. Also, the benefits of stock loan lotteries are greater in an economy with market frictions such as transactions costs, leverage constraints, and taxes.