Should you invest in “popular” stocks? New research suggests that popular stocks may underperform compared to less popular picks. Before you load up the truck with your favorite fun and fashionable stocks, consider the pros and cons:
1. It’s easy to get invested!
It’s easy to invest in a portfolio of companies that are popular right now. Many North Americans shop via Amazon, own Apple phones, and covet their neighbour’s Tesla. The stocks have name recognition, people know what the companies make, and there’s even a cool factor. No analysis required, the stocks are liquid so buying shares can be done at any time: ready, set, invest.
2. It’s a great way to get started investing.
The three most common reasons that some women don’t invest?
- No time. Time is a scarce resource for everyone, but it’s even more precious for those who are often juggling responsibilities of work, family and eldercare. Aka: a lot of women.
- No interest in taking a course. Many people know that investing is important (even critical) to their financial future but they just aren’t interested in learning about it formally.
- Perfectionism. When it comes to getting started, many women don’t want to take the plunge until they understand absolutely everything. But perfectionism most often leads to “analysis paralysis” and no decisions end up being made.
A great way to build confidence with investing (or anything else, for that matter) is to practice. It’s more likely that you’ll be interested in following popular stocks and there’s the added benefit of having something to talk about at cocktail parties!
Once you get used to following a handful of popular stocks you can then venture into different categories and build a properly diversified portfolio. The important point is that you started.
1. The popularity premium.
It’s human nature. If you like something, you’re more likely to be willing to pay more for it. In the investment biz that extra amount people are willing to pay is called a “premium”.
Professional money managers consider various risk factors before they buy a stock, and one of these considerations is the investor demand for a stock. But up until recently, valuation models hadn’t formally captured the idea of popularity and the potential impact on stock price.
New research has resulted in a new model (PAPM) that recognizes that high popularity characteristics (as well as risk) negatively affect expected returns and we can now value a variety of attributes according to the demand for each of these characteristics. Sound like fun? If so, read more here about the Popularity Asset Pricing Model.
The short version? Popular stocks normally come with a higher price tag and underperform.
2. Buyer beware.
How well will your popular portfolio actually perform?
It’s anyone’s guess. As always, investing success can only be measured retroactively. Popular stocks probably have as much chance of outperforming or underperforming over very short time periods as any other type of stock – the problem is what happens over the longer term.
Paul D. Kaplan, Ph.D., CFA, Director of Research with Morningstar Canada discusses this concept in Putting a Price on Popularity: “People who buy a stock because of characteristics that are popular, for reasons that have nothing to do with risk and return, they’re the willing losers. They’re willing to give up return in exchange to get the characteristics that they like.”
It stands to reason that if you can avoid falling into the trap of buying what all your friends are buying you might perform better.
So…should you invest in popular stocks?
Sure…go ahead. Live a little. But not with your entire life savings!
As per Kaplan: “The trick there, of course, is to identify the stocks which are becoming more popular, buy them, but then sell them before they lose their popularity. That’s a tricky game to play.”
Whether you’re buying popular stocks as a way to get started in investing, or whether you’re looking to add them to your existing investment strategy…it’s best to think about popular stocks as you would any other alternative asset class. They have a role to play in your broadly diversified portfolio but don’t invest more than 10% in this category.