How Your Brain Picks Stocks

Our brains want to use the least amount of energy possible, all the time. If they had their way, they'd be mush, fed on reality television and piles of refined sugar. This evolutionary desire to acquire energy while exerting none follows us through all our lives. Inventions that allow us to be even lazier make billions. And investments that are easier to comprehend perform better than their counterparts. But it isn't even the business itself that must be easy to understand.

If the company name and ticker are more easily digestible to our mind, that stock will perform better, which is a great reminder of how inefficient markets can be and how wildly out of touch stock prices can be with business realities.

Why would a stock that's more easily pronounceable perform better?

Disfluency
Adam Alter of the NYU Stern School of Business studies decision-making and social psychology. He recently had a conversation with Edge that explained the difference between fluent information -- information that is familiar and easy to process and understand -- and disfluent information, which makes our brain work a little harder because of its unfamiliarity.

He covers a wide range of outcomes from the differences between the two forms of information. One example shows how new lawyers with names that are easier to pronounce ascend through the ranks inside law firms much more quickly than the unfortunate souls with tongue-twisting names. But one of the most interesting examples covers financial behavior.

If you look at the performance of stock over the first day or week after it's come out on the market, you can predict its performance pretty well by looking at how easy it is to pronounce its name. And, again, that's controlling for all sorts of other factors like which industry the stock is from, the size of the company. It seems that there's a halo that stocks acquire when the company name is easy to pronounce. We have also shown the same effect when you look at the ticker codes of the stock.

With no relationship to cash flow, valuation, management, or the numerous other characteristics of companies that we pore over before making an investment, our brains value how easy it is say its name.

Take a look at the CAPS portfolio of WordTicker, which picked stocks based solely on tickers that spelled words. Even though many of the picks were made in early 2008, when the S&P 500 was trading around 1,300 before the market crashed -- not a great time for valuations -- the portfolio is in the 97th percentile in terms of performance. Sourcefire  (UNKNOWN: FIRE.DL  ) , a cybersecurity provider, had negative income every year until 2009. Yet if you let your lazy brain pick it based on its ticker, then you have enjoyed more than 800% since 2008. And since the company proved it could actually earn money in 2009, its stock has more than doubled.

Obviously, there's a solid business behind Sourcefire, and its performance does not owe entirely to its fun ticker. North American Palladium's  (NYSEMKT: PAL  ) ticker seems friendly, but after the company invested in and divested gold mines over the past few years, lost money over the past five years, ran into expansion obstacles, and reshuffled top management this year, its share price is down nearly 50% from a year ago.

The market is worth what we value it
Just because we subconsciously savor the easy-to-say stocks doesn't mean a portfolio based on them makes sense. Sooner or later, real financials break through this cognitive bias. But it's a great reminder that markets aren't always the smartest due to their human component. Just look at the graph of Physicians Formula Holdings' (FACE) performance around the time of Facebook's IPO.

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


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  • Report this Comment On April 01, 2013, at 12:17 PM, bigmac7406 wrote:

    You really have a grudge against $PAL that comes out in your articles. Reading your articles make me question why I paid good money for Motley Fool.

  • Report this Comment On April 01, 2013, at 4:18 PM, Chickenpookie wrote:

    Take OINK, for instance.

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