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Neon Stocks Not the Best Buys
All that Glitters is Not Gold

by John Price

If you are not using selection software such as Conscious Investor when choosing stocks you are losing money. This is the conclusion of recent research described in the following article that appeared in the Smart Money section of "The Australian Financial Review" (October 4-5, 2003).

"Glitter" stocks are those stocks that are attention-grabbing for reasons such as they had high trading volume, there were extreme movements in the price whether up or down, or the stocks were in the news. Research shows that individual investors tend to buy these stocks. The same research shows that, unfortunately, such stocks underperform the market on average.

This is just another reason for having screening software such as Conscious Investor so that you can instantly run through thousands of stocks looking for quality investments. Without it most people end up with glitter stocks. And we know what the old prospectors used to say, "all that glitters is not gold."

How do Mr. and Mrs. Average Investor choose their stocks? Careful analysis of reports from stockbrokers? No time. Interviewing members of the board and senior management of the company? It is unlikely their calls would be returned. How about looking at stocks with extreme price changes? Now you are getting closer. If you also added the “glitter” stocks that are in the news or have abnormally high trading volume you would have the bases well covered.

Recent research by Brad Barber and Terrence Odean of the University of California shows that individual investors tend to purchase stocks on the days after there is some sort of attention-grabbing activity. Specifically, they tend to purchase stocks on the days after there was high trading volume, when there were extreme movements in the price whether up or down, and when the stocks were in the news.

Earlier studies by Barber and Odean showed that investors were systematically reluctant to sell their stocks for a loss. We hate to have to admit that we have made a mistake. So we hang on to losers even though from a tax perspective it is better to declare our losses as soon as possible. Even more significant is the fact that by hanging on to their losers, investors were hurting their overall performance.

In this recent study the authors set out to look at the other side. Why do investors choose to buy particular stocks? This is a formidable problem for investors. In the USA there are over 10,000 stocks to choose from. In Australia, over 1,500.

They looked at the trading accounts of over 700,000 individual investors and 43 professional money managers. The results show that there is a difference between methods used by individual investors and professional investors. It seems that professional investors are less likely to invest in attention-grabbing stocks. Possibly this is because they have more time and resources, including computer programs such as Conscious Investor, for monitoring a larger range of companies.

In contrast, individual investors with limited resources are more likely to purchase stocks that capture their attention in the ways mentioned above such as stocks that are in the news.

Of course, there is nothing wrong with this approach if their choices turn out to be profitable. Alas, on average this does not turn out to be the case. Consider momentum investors who believe that if a stock rises in price, it is likely to keep rising. The researchers found that more people bought a stock when there was an abnormally high return on the previous day. Yet this resulted in underperformance over the next month against the stocks that were sold and against the overall market.

A similar result held for contrarian investors who believe that if there is an abnormal dip in price, then there will be a profitable rebound. Once again the outcome was underperformance over the following month.

You can see the details in the following chart for the four attention-grabbing categories: high volume, abnormally high return, abnormally low return and news releases.

Underperformance Over the Following Year
Share Category
High Volume
High Return
Low Return
Source: Brad Barber and Terrance Odean. We assume the strategy is rolled over each month.

When these results are looked at in the context of research by Daniel Kahneman, the 2002 Nobel Prize winner in economic sciences, we shouldn’t be surprised. Kahneman showed that we make evaluations of an extended experience based on the most extreme component of the experience and by the most recent component. Everything else is given less importance. He refers to it as the peak/end rule.

An extremely painful surgical procedure will be reported as less severe if a less painful period is added at the end. The painful period can even be extended by the medical practitioner so long as the end is less painful.

In the case of the stock market, suppose we are thinking of making a purchase. The peak/end rule would bias us towards those stocks that have drawn our attention most strongly or about which we have the most recent news. And if these happen to be the same event such as recent high volume, then the relevant stock will be even more dominant in our mind as a stock to buy.

Not everyone believes that investors can be so easily influenced or that share prices are so rubbery. One of these is Myron Scholes, the Nobel Prize-winning economist, a supporter of the school that teaches that the share price always describes the true value of the company.

When he expressed this opinion to Bill George, the former CEO of the billion dollar company Medtronic, George replied, “Myron, I sit in the CEO’s chair, and I can tell you how easy it is to raise our stock price in the short term… We can go out and hype the stock.” The story goes that Scholes flung his pencil down on the table.

The point is that whatever the short-term effect, Barber and Odean’s research shows that any resulting price rises are not likely to stay for long. All in all, investors would be well to take heed of the saying known to the old prospectors—all that glitters is not gold.


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