So you just got a hot stock tip from a colleague at work. Or maybe you heard a stock recommendation on a TV show. Better yet, your hair dresser told you about a really hot stock that’s a sure thing because, well, it doubled just this past year.
And oh, by the way, you should feel good about buying these stocks because these companies will change the world as we know it – and for the better no less.
These are popular stocks. We all heard such stories. In most cases, they went up a lot recently, sometimes doubling or even tripling. In other cases, they may be a recent IPO that hasn’t had time to double as a publicly traded stock just yet. But we all know that’s okay because they have a hot product. Therefore, the sky must be the limit of course – or so the dialogue goes…
Owning Popular Stocks is a Love Affair
Buying popular stocks is a love affair. It feels really good to own them because people talk about them. It makes us feel smart because they went up so much already, despite the fact that we haven’t made a penny of profit from them yet. It makes us feel hip because we are part of the exclusive crowd who owns the hottest stocks in town. It can also be perceived as a status symbol because, well, we are effectively part of a company that is changing the world after all. Something to be really proud of.
There’s no question that owning popular stocks has social and emotional benefits. But is it profitable? Isn’t making money the whole point of investing after all?
Are Popular Stocks Profitable?
Roger Ibbotson, a Yale finance professor and founder of Zebra Capital, along with Thomas Idzorek, the president of Morningstar, have recently published a paper called Dimensions of Popularity. In their paper, they analyze the annualized returns and volatility of stocks vs. their popularity. They define stock popularity as the share turnover ratio, which is essentially the number of shares traded over a period divided by the total number of shares outstanding. So a popular stock is one where that ratio is high, meaning that it trades a lot. A less popular stock has the opposite behavior: it trades relatively few shares compared to the number of shares outstanding.
They analyzed over 3,000 stocks, and they organized their results into four quartiles. The bottom quartile contains the least popular stocks whereas the top quartile has the most popular stocks. I built a bar chart using their results here so we can better see what that means in a graphical format.
The red bars represent the annualized return for each of the four quartiles. The blue bars show the standard deviation for each quartile. Recall that standard deviation is a measure of the volatility and a reasonable way to represent risk as discussed in my post Standard Deviation as a Measure of Risk.
This chart is quite telling. It shows that popular stocks (Quartile 4) are the least profitable group (8.27%) AND also the riskiest (highest standard deviation at 28.35%). On the other hand, you can see that the least popular quartile (Quartile 1) shows the best returns at 15.51% and also the lowest risk (20.18%). This is a huge difference because these are compounded returns.
Need I say more?
Of course, buying popular stocks can be a fun way to have an engaging discussion at a cocktail party. So here’s my take on this: do talk about popular stocks at cocktail parties, but buy the unpopular kind. This way you get both benefits. You become part of the crowd and enjoy all the social benefits that presumed ownership can give you. And meanwhile, your portfolio’s profit potential and risk profile will be much more attractive so you can afford to retire on the beach one of these days. 🙂