It may seem counterintuitive, but over time, stocks that are less popular seem to outperform their more popular counterparts—and they do so with less risk and generally less volatility, according to investment experts Roger Ibbotson of the Yale School of Management and Tom Idzorek of Morningstar Investment Management.
The two finance experts, writing in the 40th-anniversary issue of “The Journal of Portfolio Management” in September, stress that this analysis is meant to look at the concept of popularity within an asset class, like stocks, not between asset classes.
The dynamic seems to go as follows: Investors like a stock, and its price goes higher; investors don’t like a stock, the price goes lower.
“Thus, the asset with the more desirable characteristics should have lower expected relative returns, whereas the asset with less desirable characteristics should have higher expected relative returns,” Ibbotson and Idzorek said in their report.
They added the following perspective: “Although risk is clearly unpopular, it is only one dimension of popularity. Popularity can include all sorts of other characteristics that do not fit well into the risk and return paradigm.”
The notion of popularity and stocks may not initially appear scientific, but Ibbotson and Idzorek did their homework, of course.
They sliced and diced data associated with the largest 3,000 publicly traded companies from 1972 to 2013. As part of the analysis, the experts ranked the companies in relationship to how much turnover (or popularity) they had in prior year.
The less popular stocks, they found, have both lower turnover and less risk (or beta).
In terms of average annual returns, the less-popular stocks improved between 14.42% and 15.51% vs. returns of 8.27% and 12.80% for their “hot” counterparts.
The less popular stocks also had less volatility, as measured by their standard deviations, which were 20.18–20.66 vs. 22.74–28.25 for the more popular shares.
“Many of the well-known market premiums are associated with unpopular stocks. Unpopular stocks tend to be smaller, less liquid, and perceived as lacking growth potential,” explained Ibbotson.
“These stocks, with their low relative prices, may offer investors better future performance as they move along the spectrum toward popularity,” he stressed.
In their article “Dimensions of Popularity,” Ibbotson and Idzorek identify some of the most common market premiums and anomalies.
These include the following:
Smaller-capitalization stocks outperform larger capitalization stocks;
Value companies beat growth companies;
Less-liquid stocks best those with more liquidity; and
Stocks trending upward will continue to move.
The financial specialists note that the current risk-return framework does not really explain these premiums and anomalies.
Hence, they came up with the unifying “theory of popularity.”
“We need a new model for explaining investment performance that goes beyond risk and return. Popularity may be a better lens through which to view investment behavior,” Ibbotson said, in a press release issued by Morningstar.
The significance of this analysis, the experts describe, is that it adds to our understanding of financial decision-making and, thus, may help advisors and investors better respond to market signals and dynamics.
“Investors who are overly confident may go after the most popular stocks and end up driving the price too high. We seemed to see this in the Internet bubble,” Ibbotson and Idzorek said.
“Investors may favor stocks that are in the news or when information is most readily available, ignoring the stocks where information takes more work to dig out. Herding is also a behavior theory, and of course popularity and herding are similar concepts,” they explained.
In other words, the herd mentality ends up hurting investors. They pile into stocks, rather than investing in less-popular ones that outperform their “hotter” counterparts.
To Ibbotson and Idzorek, the dynamic makes sense—and it’s one that investors and advisors can benefit from, by responding differently that “the crowd.”
“Strategies that involve buying stocks that are too popular should have lower returns, whereas buying less popular stocks should have higher returns,” they shared. “By its nature, a strategy that focuses on buying the less popular stocks will be contrarian. Investors will have to go against the crowd, buying the lower priced securities to achieve higher returns.”