Investors err in assessing stock returns. Prominent outliers attract undue attention and garner more interest than stocks with market-average returns. However, such stocks don’t necessarily make better investments; in fact, this strategy results in reduced returns for investors.
Salience, a well-recognized behavioural error, influences investors’ decision-making. Stocks with returns significantly deviating from the average tend to attract attention and are more likely to be purchased, a behavioural finance bias evident in various contexts. Analogously, we tend to notice cars around us only when intending to cross the street, illustrating the concept of “conspicuousness.”
While the examples may seem apparent, the same applies to stocks, yet investors often fall prey to this bias. People are naturally drawn to standout stocks with returns far from the average, whether positive or negative. Consequently, these stocks witness accelerated buying, leading to price hikes.
Contrary to this behavioural tendency, research suggests that these standout stocks do not necessarily represent better companies. On the contrary, their expected returns are often lower than those of stocks with average returns, or even negative. Investors, therefore, incur losses by succumbing to this bias.
A more pronounced form of this phenomenon occurs in the stock lists featured in newspapers, such as De Tijd or Het Laatste Nieuws, where daily winners and losers are highlighted. Investing in these highlighted stocks significantly diminishes performance, leading to a loss of returns. Succumbing to salience translates to a monthly loss of 1.5 per cent against stocks not listed.
Gertjan Verdickt, an assistant professor of Finance at KU Leuven and a columnist at Investment Officer, emphasizes the importance of avoiding the allure of standout stocks in the pursuit of sound investment strategies.