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The role of the micro-cap analyst should be to focus on optimizing both tails of the return distribution. While the annual returns of the index constituents are highly skewed, the daily returns of the index fit more closely to a normal distribution. The comparison can be done very easily by using the historical return analysis tool in Eikon. The significant positive excess kurtosis can also be observed by plotting the daily returns of the TSX Venture Composite Index against a normal distribution. Like VC funds, micro-cap investors must also deal with a sharply skewed return distribution and a significant positive excess kurtosis.

It helps investors to understand the importance of convexity in mitigating losing positions. The extreme positive excess kurtosis of the return distribution underscores the magnitude of the fat tails. The parallel between micro-cap stocks and lottery tickets becomes apparent when looking at the annual return distribution of the S&P/TSX Venture Composite Index constituents. Micro-cap stocks and lottery ticket similarities This is particularly true for junior resource companies where the global sentiment around the commodity complex plays an important role in determining the fear discount or the greed premium. These same factors can explain some of the risk premiums present in micro-cap stocks and justify why junior stocks can be systematically undervalued or overvalued in certain periods. Factors like fear, hope, camaraderie or fun are often used by lottery and insurance buyers to justify decisions that have a negative expected return. Gaming companies and insurance companies can be viewed as volatility traders generating profits on the delta between perceived and realized risks.

Whether rational or not, people do buy overpriced insurance policies and lottery tickets. This framework is in sharp contrast with the classic mean-variance model that considers investors as rational and risk-averse. Understanding the behavior of lottery players helps us answer many questions about the construction of a micro-cap stocks portfolio and the different risk premiums associated with it. Stock traders often make fun of lottery ticket buyers, but the two have much in common.