Dead Presidents! - India Equity Research: May 31, 2006

Wednesday, May 31, 2006

Simple sounds make for sound investments

Easily pronounced stocks do better on the market.

For those of you struggling to pick a winner in the complex world of stocks and shares, help is at hand. A psychology study has found that, at least in the short-term, stocks with names that are easier to pronounce consistently outperform those with more confusing monikers.

According to Adam Alter and Daniel Oppenheimer, psychologists at Princeton University, New Jersey, it's all about fluency. When people try to understand complicated information, they tend to focus on the simplest parts. This means that people naturally favour things that are more fluent, and easier to think about.

To test whether this behaviour influences what people buy on the stock market, the duo asked a group of ten undergraduates to rate the fluency of 60 fictional stock names, according to how difficult they were to pronounce. Companies such as 'Hillard' or 'Barning' were judged fluent, whereas 'Xagibdan' and 'Creaumy' were classed as complex names.

A second group were then asked how they thought each of the stocks would perform. Perhaps unsurprisingly, they tipped the nicely named stocks for success.

Taking stock

So far, so what, you might say; these were fictional stocks picked by undergraduates with no stake in the matter and nothing much to judge the companies by. But the scientists argue that this roughly simulates the launch of completely new shares on to the market, when investors are unlikely to have much information about the company beyond its name, which could consequently become an influential factor.

To check, Alter and Oppenheimer did a second study looking at 89 real stocks that were traded on the New York exchange between 1990 and 2004. They asked 16 undergraduates to grade the fluency of the stock names on a sliding scale. Then they checked on the stocks' performance.

As anticipated, the more complex a share's name, the poorer it performed on the first day of trading. The effect appeared to wane as time went on; after 6 months, when more information about the stock was presumably available, the name alone couldn't be used to predict a single stock's performance.

But the overall impact on a portfolio of stocks was, in this case at least, substantial. Alter and Oppenheimer calculated how much a US$1,000 investment would have fared if it were invested in either the ten most fluent, or ten least fluent, shares. After just one day, the fluent portfolio was $118 ahead of the tongue-twisters; and after a year, it was US$333 up.

"It's a very large effect," says Oppenheimer, who reports the work in the Proceedings of the National Academy of Sciences¹. But so far the researchers have only trialled one bunch of stocks, so it is unclear how robust this trend really is. "I'd caution people not to change their portfolio on this basis."

Shares pronounced up

One explanation might be that bigger companies simply have more marketing people to dream up a catchy title, or certain business sectors may naturally tend towards simpler, more pronounceable names. But after a thorough statistical analysis, the psychologists concluded that there was no link between a company's type or size and its stock performance.

To prove the point, the pair finally analysed how well companies performed on the basis of their three-letter stock ticker code, which a company doesn't determine itself. Amazingly, pronounceable codes such as KAR still tended to do much better than unpronounceable ones such as RDO. Once again, the pair invested their fictitious $1,000, and found that the fluent codes were $85 up on the first day, although the portfolio was just $20 ahead after a year.

Oppenheimer says that considering psychological factors such as name choices could help to improve economic models. Because shares are traded by human beings, he reasons, behavioural foibles will undoubtedly influence how the market works.

It sounds like a winning formula, but are Alter and Oppenheimer ready to bet the farm on snappy-sounding stocks? "No," says Oppenheimer. "I don't have the money to invest."

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Investing: The mirror says it all!

In making an investment decision, apart from returns, there is one more very important factor that weighs heavy on investors' minds - risk. Simply defined, it is the uncertainty of happening/non-happening of a certain event(s) that is likely to affect future returns.

A risk is generally attributed to external factors that create disturbance in the existing scheme of things. Some of these external factors are geo-political uncertainties (elections, terrorist attacks and wars), financial crisis and economic downturn. However, what stockbuyers generally fail to understand is that, apart from these external factors, there is one very big 'risk-factor' that is very inherent (or internal) to them. This internal risk is that of 'indiscipline'.

By indiscipline, we mean that stockbuyers tend to forget the basic scruples of safe and sound investing, as they are then lured by the high probability of earning 'a big bang for their buck'. In times when everything around seems promising and stock markets rise incessantly, discipline generally gives way to chaos. And this leads to even the best of investors putting their money into the worst of stocks believing that their invested company is the 'next big thing'. Ironically, as just these very times when stockbuyers need to stick to the fundamentals of sound investing, they seem to forget these (the fundamentals).

This is where the 'behavioral' aspect of investing gains importance. And this is the time when a stockbuyer, before making the next investment (say investment 'X') should look into a mirror, and ask certain strict questions to himself. First, he needs to ask whether he understands his investment 'X' as well as he thinks he does. This would include:

asking whether the investor has enough experience of similar kind in the past. This is like, when an investor is thinking of investing in say, Tisco, he should ascertain what has been his previous experience with the company;

asking what has been other people's track record in the past in making a similar kind of investment;

ascertaining how much returns should his investment 'X' generate for him to break-even after his taxes and cost of making the investment. This would make clear the price that he would be ready to pay for the value of the investment 'X'.

Secondly, the stockbuyer needs to ask himself as to what would be his reaction in case his 'correct' analysis about investment 'X' goes wrong. This would then involve:

asking whether he has adequately allocated his assets (into equity, debt, insurance) to tide over losses from his investment 'X';

asking whether he has a track record of controlled behaviour (i.e. acknowledging that he made a mistake) or else he would be a part of the overall chaos when things go wrong;

asking whether he is relying on a well-calculated approach and what is his tolerance level of risk. He could find out his tolerance level by studying his past losses.

Now, while the answer to the first question (i.e. whether the stockbuyer understands his investment 'X' as well as he thinks he does) would be indicative of the 'confidence' level of the stockbuyer, the answer to the second (i.e. what would be his reaction in case his 'correct' analysis about investment 'X' goes wrong) would speak about the 'consequences' in times his investment decision goes wrong. If the stock buyer has clear answers for all the abovementioned questions, he would only make his larger task (of making investment 'X') easier. Thus, before you (as an investor with a long-term horizon of 2 to 3 years) invest, make sure that you have pragmatically ascertained your probability of being right and as to how would you react to the consequences of being wrong. Always, look at the downside before the upside. And always, look into the mirror before investing! Investing: The mirror says it all!