Investors have hundreds of shares to choose from even if we confine our selection only to the UK. So how do we decide which to buy? New research shows that many of us do so for bad reasons.
The problem here is that we all have limited attention. We cannot possibly monitor hundreds of stocks. Obviously, we only buy those that come onto our radar – and those that do so are not the best investments.
A recent paper by David Hirshleifer of the University of California at Irvine and colleagues points this out. They show that companies that are in the news, or those that have big earnings surprises (both good and bad), tend to attract more buying.
This means that our attention and therefore our buying is disproportionately drawn towards more volatile stocks – because these are the ones most likely to make the news by moving a long way.
It also means we have a bias towards lottery-type stocks – those that have a tiny chance of rising a lot. Imagine two stocks, one rising a steady 1 per cent per month, the other doing nothing all year but jumping 10 per cent in a day. The latter is more likely to grab our attention, while the former goes under the radar – but it’s the steady riser that is the best pick.
And herein lies the problem. Although volatile and lottery stocks get disproportionate attention they are not the ones that deliver the best returns. Quite the opposite. This isn’t just for the obvious reason that a share that’s jumped a lot is likely to have discounted all the good news it is going to get. It’s also because lottery stocks and volatile ones tend on average to actually do worse than others. It’s no accident that the Aim index, which contains many of this type of share, has systematically underperformed mainline stocks so badly – it has given a total return of only 28 per cent in the past 20 years while the All-Share index has returned 168 per cent.
These, however, are not the only biases in our attention. Katrin Godker at the University of Hamburg and Peiran Jiao, and Paul Smeets at Maastricht University point out another bias. They did laboratory experiments in which people chose between artificial risky and safe assets and saw the subsequent performance of both. A week later, they asked people to remember their choices and the returns on them. They found that those who had chosen the risky asset that did well remembered its performance much better than did those who had chosen a risky asset that did badly, even if those good returns were due to just luck.
This is consistent with work by Guiliana Mazzoni at the University of Hull. She shows that we construct our memories to conform to our current view of ourselves; for example, we forget the extent to which we have changed our minds about important matters. Because we want to believe we are good investors, we therefore tend to forget our bad investments and remember our good.
This can lead to mistakes. It encourages us to take on more risk, to hold individual stocks when we should diversify; and to follow strategies (such as buying speculative stocks) which have only very patchy performance.
It’s not just what we remember that is selective, however. So too is what we talk about. We are more likely to discuss our good stock picks with friends and acquaintances than our bad ones: many of you probably have friends whose discussion of their investments would have you believe that they outperform Warren Buffett. Economists at the World Bank show in a recent paper that this can lead novice investors to think that stock-picking is easier than it really is, which emboldens them to trade too much, and badly.
This corroborates earlier work by Hans Hvide at the University of Aberdeen and Per Ostberg at Zurich University. They show that people who work together tend to own similar stocks – which is consistent with stockpicking decisions being influenced by word of mouth and peer effects. But, they show, such shares do worse than others.
All this should warn us of an underappreciated problem. It is not just our rationality and our knowledge that are limited. So, too, is our attention. Whether we notice a stock or whether we remember it depends upon how it comes to our attention. And it might do so because it is a bad investment – because it is more volatile than other stocks; or because it has risen in price; or because friends and colleagues, having stumbled by accident onto a good stock, are bigging it up.
Our attention is selective, and it can select for bad rather than good. Of course, this isn’t always the case. Sometimes the very fact that we see companies every day can lead us into good stocks – as holders of Greggs (GRG) will tell you. But it is the case more often than is good for us. And we should be on guard against it. Whenever you are thinking of buying a share, just ask: how did I first notice it? In some cases – especially smaller volatile stocks – the very answer to the question might give you a reason not to buy it.
