The problem with popular stocks
No industry, not even the entertainment business, runs as much on buzz as the investment industry. Hot stocks see trading volumes soar as they are touted by arm-waving television commentators. Nobody wants to be left out of a trendy stock: Individual investors want to name-drop them at cocktail parties, while professional investors want to make sure their clients see them in their monthly portfolio statements.
The only problem? This kind of buzz can kill an investment idea.
In a paper called "Dimensions of Popularity," Roger Ibbotson and Thomas Idzorek compiled more than 40 years of stock market data to measure the effect of popularity on investment returns. The conclusion in a nutshell: When it comes to stocks, you are better off dancing with a wallflower than with the belle of the ball.
The price of popularity
How do you measure the popularity of a stock? Ibbotson and Idzorek did it by looking at share turnover -- essentially, the trading volume relative to the number of shares outstanding. Stocks that generate a high level of interest relative to the company's size will have high turnover. The study considered these to be the most popular stocks.
Breaking stock turnover down into four quartiles, Ibbotson and Idzorek found that the most popular stocks in any given year went on to have an average annual return of 8.27 percent the following year. In contrast, the least popular stocks went on to have an average annual return of 15.51 percent the following year. All four quartiles lined up in order: as the quartiles increased in popularity, they decreased in return. They also increased in volatility.
In short, buzz is bad for stocks.
Applying the lessons
How do you apply this study to your investing? Looking for low-turnover stocks is the most direct way, but there are some broader conclusions to be reached as well:
1. The best way to deal with momentum is to get out of the way. Emotionally, it is a natural thing to want to jump on a bandwagon, and some professionals even consciously chase momentum as an investment approach. However, when momentum is moving too fast, you are better off getting out of the way than trying to jump on.
2. Don't mistake investing for a popularity contest. The purpose of your portfolio is not to be a source of anecdotes about your hot stock picks. Besides, if you earn strong returns, you will have more than enough bragging rights.
3. The more attention a stock gets, the harder it is to have a unique perspective. It is hard to profit from what everybody already knows. It's much easier to have unique insight on an overlooked stock than on one that's on everybody's lips.
4. Overlooked does not mean beaten up. Contrarian investors often like buying stocks whose prices have suffered, but that is not quite what this study is suggesting. Low turnover does not necessarily equate to a plunging stock price, and when news is bad, heavy selling volume might increase a stock's turnover. In other words, you are not looking for stocks people hate so much as you're looking for stocks they ignore.
The herd mentality is a powerful force in investing. If you find yourself running with a herd, look around to make sure you aren't surrounded by lemmings.
More from MoneyRates.com: