The Lottery Effect

One way optimism in security selection is evidences is by the lottery effect. Investors seem driven to investments as having the potential for large gains, such as biotech companies working on cancer cures or mutual funds investing in developing countries. Behavioral researchers have found their decision-makers tend to overweight the strength of information signals (i.e. return potential) and underweight their probability of occurrence (i.e. likelihood of success).

Simply stated, investments perceived as having high return potential tend to be overvalued.

-- Greg Forsyth, OnInvesting, Summer 2007