Wednesday, July 23, 2008

High Recognition Investing

Q: You are the author of a famous study on how people use instinct in investing. Why this topic?

A: Because intuition often underlies stock picking. Ordinary investors will frequently pick a company they’ve heard of before. We call this the “recognition heuristic,” and it basically means “go with what you know.” I was curious: is this effective? In the 1990s, we interviewed 360 pedestrians in Chicago and Munich. We asked if they were familiar with the names of German and American corporations traded on the stock exchange. Using the names of the most frequently recognized companies, we then made up investment portfolios.

After six months, the high-recognition portfolios, on average, gained more value than the Dow and DAX markets and some big-name mutual funds. The high-recognition portfolios did better than a portfolio we created from randomly picked stocks and another made up of low-recognition stocks. Over the years, we’ve repeated this experiment twice, in different ways. Each time, the intuitive wisdom of the semi-ignorant outperformed the calculations of the experts.

Interesting. Sure would take a lot less time than doing financial research. I wonder why this works.

5 comments:

odograph said...

I was in a startup with a name similar to a real dot-com high-flier. Many people would call our receptionist every day, thinking we were them.

I made a lot of money in that startup ... coincidence?

odograph said...

Oh, and "that's how I roll."

Fat Knowledge said...

Odograph,

I like the way you roll. So, did you work for Zahoo, Doogle, or Wiibay? :)

rahulbrown said...

I would submit that the recognition heuristic works mostly on the principle that the stock market is a mass psychology scam where most of the gains and losses are all speculative, rather than directly connected to company growth or decline. And yet when you create that system, you also become slave to it and need to continually project your image to manipulate the mass psychology. Someone business pioneer famously said that half his advertising budget was a total waste, but he just didn't know what half. I think he meant that only half contributed to increased sales while the rest just feeds the hype that feeds the insanity that drives the stock price.

Fat Knowledge said...

Rahul,

Interesting idea that advertising could be spent in an attempt to increase the value of a stock (increasing P/E ratio) rather than increasing sales.

As for whether the stock market reflects the actual value of companies, I go with Warren Buffet who said: "In the short term the market is a popularity contest; in the long term it is a weighing machine."

In the short term a stock might just be a mass psychology scam, but I don't think that would hold up for the long term (you wouldn't happen to have an example where it has would you?).

And as for the advertising quote, I believe this is the one you are looking for:

“Half the money I spend on advertising is wasted,” John Wanamaker, the owner of America's first big department store, allegedly said in the 1870s. “The trouble is, I don't know which half.”

I always liked that quote.

I don't agree with you though that the other 1/2 is useful to increase the stock price. I think it is just wasted as it is shown to people who have no interest in the product or stock at all. Most of the ads that are displayed when I am surfing have absolutely zero impact on me for either their product or their stock.

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