Maximilian Franke at the University of Ulm studied thousands of bets on football matches across Europe between 2006 and 2014 and found a systematic pattern: gamblers bet too much on outsiders and not enough on favourites. Because of this, outsiders are over-priced while favourites are under-priced - so much so, he estimates, that a strategy of backing extreme favourites (those with more than an 85 per cent chance of winning) would have earned a return of over 50 per cent.
This is no isolated finding. The same thing has long been known in horse-racing; it's called the favourite longshot bias. And it's consistent with the claim in Daniel Kahneman and Amos Tversky's classic paper on prospect theory - that people over-estimate low probabilities and under-estimate high ones.
Now, we can think of small Aim stocks as being like longshots in horse racing or football: their chances of high returns are, in fact, small.
The size distribution of Aim stocks tells us this. Only five of the 1,013 companies in the index have a market cap of over £1bn - the biggest being ASOS with a market cap of £3.7bn - but 695 are worth under £50m. This fact alone tells us that it is very rare for small stocks to get big. This is because there are massive obstacles to growth: competition from big entrenched rivals; diseconomies of scale; or the fact that a boss who's great at starting a company might not be able to manage its growth so well; and so on.
Investors under-estimate these barriers to growth and so pay too much for small growth stocks. In effect, they bet too much on longshots. The upshot is that Aim stocks have done terribly over the long term. Since its inception in 1995, the Aim index has fallen by 25 per cent while the main market has risen by over 80 per cent.
This pattern isn't confined to the UK. Robert Whitelaw at Stern School of Business in New York points out that lottery-type stocks (those offering a small chance of big returns) have also done badly in the US.
All this poses the question: why is it that investors over-estimate low probabilities and so pay too much for longshots such as small speculative stocks?
One reason is the availability heuristic; the tiny minority of outside bets that paid off loom large in our minds, and this causes us to over-estimate their likelihood. Everybody knows that Leicester City won the Premier League having been a 5000-1 shot at the start of the season, but forget the countless other long-odds bets that lie as ripped up slips on bookies' floors. Similarly, investors look for the "next Facebook" while overlooking the fact that the next boo.com is much more common.
A second problem is overconfidence: investors over-estimate their chance of spotting growth and under-rate the extent to which it is, in fact, random.
You might object that clever investors should know that Aim stocks are usually over-priced and exploit this fact. But they can't. Because they are illiquid and volatile, smaller Aim stocks are pretty much impossible to sell short. This causes them to stay over-priced, and so fall over the longer run as their owners finally give up hope.
Now, none of this is to say that you should rush to dump all your Aim holdings. There's an offsetting consideration. Aim stocks, even more perhaps than other shares, are driven by sentiment. And this sentiment tends to feed on itself, with rising prices sometimes leading to further rises. For this reason, it has in the past been profitable on average to buy Aim stocks when their prices are above their 10-month (or 200-day) moving average. And this is the case now. Aim investors now might therefore be fishing in less barren waters than usual.
Personally, such a strategy is too much risk and effort for me. My fundamental point is the fact that the tendency to pay too much for longshots is common in football and horse racing as well as in equity markets suggests that it is a widespread flaw in our psychologies. One way to succeed in investing is to at least avoid the more obvious mistakes.
