The appeal of hot stocks is understandable. Your neighbor, who drives a fancy car, mentions some hot stock that he likes. Or you find a list of "hot stocks" online, featuring stocks that are surging. If a stock is up by 10% today or has doubled over the past year, it must have some merit, right? And you'd certainly like to double your money in a single year. Hot stocks are problematic, though, and we'd often do better investing in more boring and sleepy stocks.
That's the finding of respected investing experts Roger Ibbotson of the Yale School of Management and Tom Idzorek of Morningstar Investment Management. Their research showed that less-popular stocks outperform more popular stocks while frequently offering less risk and volatility.
That's interesting, because we're often taught that taking greater risk can lead to greater rewards. But Ibbotson and Idzorek's research suggests that while that risk-reward dynamic may apply between different asset classes -- for example, the stock class outperforms the less risky bond class -- it doesn't hold up within a single asset class.
Ibbotson and Idzorek studied the 3,000 largest publicly traded companies between 1972 and 2013, looking at their turnover as a reflection of their popularity. The less popular stocks saw average annual returns between 14.4% and 15.5%, while the most popular ones gained between 8.3% and 12.8%. Those are huge differences when you compound them over a few years.
The researchers explained that following the crowd, or herding, leads investors to the popular stocks and hurts their performance: "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." The solution: "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."
Famous investing researcher Terry Odean concurs. A Wall Street Journal article by Mark Hulbert last year quoted Odean, who explained:
Individual investors don't systematically search for stocks to buy. They buy the stocks that catch their attention. ... These tend to be volatile stocks, with big price moves, about which exciting stories can be told. ... Investor buying can drive up prices, volume, and volatility. ... And that, in turn, often leads to even more attention getting paid to these companies, more overpricing in the short run and underperformance in the long run.
We can't handle exciting
Here's one more reason we might want to focus on more boring stocks: because we can't handle exciting ones. Respected investing thinker Barry Ritholtz expounded on this in The Washington Post a few weeks ago, examining the seemingly meteoric rise of five hot stocks: Apple, Google, Tesla, Netflix, and Chipotle Mexican Grill, each of which has gained at least 1,000% since its IPO. He explains that even if we had had the foresight to invest in each of them early, we would ultimately have lost out on their phenomenal gains: "... each of these companies would have sent you running for the exits — repeatedly — over the years, screaming as if your hair were on fire." Why? Well, because they've been volatile. He offers details for each, such as Netflix:
Netflix has lost 25% of its value on four separate days. Not over four days; on separate occasions, it lost 25% in a single day. In one four-month stretch in 2011, it lost 80% of its value. On Netflix's worst day, it fell 41%.
Many popular hot stocks are overvalued and destined to drop, but others are likely to keep growing. Many of those, though, are so volatile that investors lose faith and bail. Again, less popular, less-volatile companies have an edge.
Of course, the idea that out-of-favor stocks are the ones to focus on is not new. The data from this study is, but long before that, value investors have been seeking out unloved and boring companies and profiting from their success. The underlying logic is clear – that stocks that have not drawn much attention are more likely to be undervalued, and that by buying them, investors can wait for their true value to be realized.
No less an investor than Warren Buffett embraces boring stocks and value investing. In his 2001 letter to shareholders, he noted: "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement."
There's a lot we can learn from investment researchers and their studies and from successful investors such as Warren Buffett. Be careful if you're thinking about flying close to the sun. There's a lot of money to be made by sticking to underappreciated gems.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns shares of Apple, Chipotle Mexican Grill, Google (C shares), and Netflix. The Motley Fool recommends Apple, Chipotle Mexican Grill, Google (A shares), Google (C shares), Netflix, and Tesla Motors. The Motley Fool owns shares of Apple, Chipotle Mexican Grill, Google (A shares), Google (C shares), Netflix, and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.