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Aim: the wishful thinking index

This under-performance contradicts common sense and economic theory. These tell us that higher risk should mean higher reward; you've got to speculate to accumulate. But for Aim, this is not true.

The risk here is not simply that Aim is more volatile than the main market - though it is. It's that Aim stocks carry more tail risk than the All-Share index; it is more likely to do really badly in bad times. For example since 1995 there have been six calendar months in which Aim has fallen 15 per cent or more, but none in which the All-Share has done so badly. To put this another way, in the 20 worst months for the All-Share index since 1995, Aim has fallen on average by 2.5 times as much as the All-Share fell. Bad times for mainline stocks, then, tend to be terrible times for Aim.

So, why aren't investors compensated for taking this risk?

One reason is that Aim doesn't just offer more downside risk than the main market. It offers more upside risk too. There have been seven months since 1995 when Aim has risen more than 10 per cent, but none when the All-Share has done so. And, of course, there are many stories of great short-term gains on particular Aim stocks.

In this sense, Aim is more like a lottery than the main market; it offers more chance of a big quick win, at the expense of more chance of a loss. However, US research shows that investors like lottery stocks, and pay too much for them with the result that their average returns are poor. This might be because they just prefer the small chance of a big win. Or it might be because they over-estimate the chances of one.

This poses another question: when are investors most likely to want Aim stocks?

It is not at times of general market optimism. Although Aim has a big downside beta - doing badly in bad times for shares generally - it has a low upside beta. In the 20 best months for the All-Share, the Aim has risen on average by only 0.6 times as much as the main market. Yes, Aim soared at the end of the tech bubble in 1999-00 when shares were at their frothiest, but this was an exception.

Instead, Aim's rare periods of significant outperformance have tended to come just after bear markets - for example in 2003-04 and 2009. This is consistent with a prediction of prospect theory - that after suffering losses people sometimes gamble more in an effort to break even. This leads them to prefer Aim stocks with their small chance of big gains.

In this sense, the occasional preference for Aim stocks has the same motive as the disposition effect - our tendency to hang on to underperforming shares in the hope they’ll come good. Both are examples of what Hersh Shefrin of Santa Clara University calls "get-evenitis". And both lose us money on average.

You might think all this is a reason to dump Aim shares; they offer long-run under-performance and investors now aren’t sitting on the sort of losses that would generate a get-even demand for them.

You’d be right. Except for one thing. There’s another circumstance in which Aim often does well - the turn of the year. Perhaps because a new year often brings new hope, Aim stocks tend to do well in January. They have risen in 14 of the last 18 Januaries - despite falling in the average month - and, across all 18 of those Januaries, have risen by an average of 3.3 per cent.

Perhaps, then, it's worth holding onto Aim stocks for a few more weeks at least.