You are going to meet your financial advisor and just saw that Apple released a new iPhone and the stock has jumped. You make a note to ask your advisor two things:
“How can I improve my returns? Shouldn’t I just buy more Apple?”
Both questions reflect normal temptations. The desire to do something to improve our returns, no matter how good they have been is a real thing. We all want to get better. The question is, how?
There is also an urge to buy into whatever is hot, top of mind, and exciting, like our Apple example. Financial news thrives on this and there is always someone on the other side of the trade waiting to sell you popular stocks, funds, or strategies. It is terribly difficult for individual investors (and their retail brokers, if they’re honest) to pick stocks successfully in the long term. The stocks provide a story, though. A story that feeds on the waves of popularity that drive share prices to emotional highs and lows.
So how can we tie these two questions for your advisor into one conversation? The truth is, if we want to improve our returns, we should consider that popularity and returns are not always related. This is true for stocks, funds, or any strategy that has attracted attention and is riding a wave of success. For argument’s sake, we will use popular and unpopular stocks as an example because we can relate to the stories behind the companies.
Popular vs. Unpopular
Say you have money to invest and can choose between two companies, both large stocks based in the U.S.
- A well-known consumer brand that has built enormous goodwill
- A charismatic CEO with a very public presence
- An environmental or social mission that makes investors feel good
- A brand that has been tarnished by scandal
- Operates in a non-glamourous industry
- Considered a “Sin Stock” (alcohol, tobacco, firearms, etc.)
With these characteristics the company could certainly grow and provide nice returns for investors. These traits could also drive the current price of the stock higher, maybe above where the fundamentals might warrant. By buying Stock A, we are part of a crowd and that can give a sense of assurance. Also, we are often willing to pay more for that feeling. When we buy shares today, we pay for the fundamentals of a good business and the premium that the market has given the stock based on its popularity.
For these reasons, a number of investors will stay away, leaving the stock to trade at a discount to its more popular peers. Research has shown that by buying these out of favor stocks instead of more popular alternatives, we can potentially increase our returns. It makes sense, by paying a lower price our future expectations should be higher.
Making Investing Decisions
Considering all of this, here is how your advisor might answer your two questions in a single sentence: In order to improve your returns, you may need to look at investment options that, unlike Apple, are out of favor. Apple could continue to do well, but if you are comparing returns to a stock that is not “hot”, then you may be disappointed. A broader example would be that the U.S. stock market has outperformed the rest of the world for a decade. Increasing your investment outside of the U.S. after such a run would be an example of shifting away from popularity to more reasonably priced markets internationally. This could be a helpful conversation to have with your advisor, to determine how willing you may be to increase your risk for the sake of faster growth. It is hard to have one without the other.
For some great, in-depth research on this topic please see the recent Alpha Architect blog entitled “The Curse of Popularity”, by Larry Swedroe. This piece walks through decades of research on the popularity premium, how to measure popularity, and the factors that influence it.