Market States and Lottery Preference: Evidence from Chinese Open‐End Funds*

Abstract

Recent studies find that investors prefer funds with lottery‐like payoffs. Using a sample of Chinese open‐end funds, we show that investors' preference for funds' extreme positive payoffs (MAXs) depend on the state of the market: it is significant for MAXs in an unfavorable market but weak or reversed for those in a favorable market. Such state‐dependent preference is irrational because, inconsistent with the flow–MAX relationship, higher MAXs under market downturns are associated with worse performance. We further document support for the salience‐theory‐based explanation for investors' preference and provide counter‐evidence for alternative mechanisms based on rational choice or changes in aggregate flows.