Revisiting the Distress Risk Anomaly: The 52-Week High Effect and Lottery-Seeking in Distressed Stocks

Objective: Contrary to the traditional notion of risk–return trade-off, prior studies document that financially distressed stocks tend to earn lower future returns than their healthier peers. Extending this strand of literature, this study revisits the distress risk anomaly in UK stocks and further examines whether proximity to the 52-week high and lottery-like characteristics of stocks help explain the financial distress anomaly, if any. Data and methods: In this paper, we analyse the distress risk anomaly using a sample of 4514 UK stocks over the period 2000–2021. The analysis is conducted using both the portfolio-sorting method and Fama–MacBeth cross-sectional regressions. Key findings: The empirical findings confirm the persistence of the financial distress anomaly, showing that high-distress stocks earn lower returns than their low-distress counterparts. Consistent with a mispricing explanation, this inverse distress–return relationship is more pronounced for stocks that are difficult to arbitrage and is stronger following periods of market optimism. Furthermore, the analysis reveals that both the 52-week high effect and lottery-like trading, independently and jointly, contribute to the poor performance of financially distressed stocks. This suggests that underreaction and overreaction interact to shape the observed overvaluation of distressed stocks. These findings remain robust to a battery of robustness checks. The results have several important implications for investors, researchers, and regulators.