Double then Nothing: Why Stock Investments Relying on Simple Heuristics May Disappoint
Article first published online: 23 DEC 2011
Copyright © 2011 John Wiley & Sons, Ltd.
Review of Behavioral Finance
Volume 3, Issue 2, pages 115–140, November 2011
How to Cite
Foerster, S. R. (2011), Double then Nothing: Why Stock Investments Relying on Simple Heuristics May Disappoint. Rev. Behav. Fin., 3: 115–140. doi: 10.1002/rbf.18
- Issue published online: 23 DEC 2011
- Article first published online: 23 DEC 2011
- behavioral finance;
- stock investments;
- survivorship bias
Behavioral researchers argue that although individuals often rely on heuristics or rules of thumb that reduce the complexity involved in predicting values, such heuristics can lead to severe and systematic errors. I test this argument in an investment context by focusing on a simple heuristic whereby momentum traders are attracted to buying stocks that have recently doubled in price in anticipation of further gains. I show that such a strategy can lead to predictable disappointment for these investors and severe underperformance relative to the market (−28% over a 4-year period), whereas investors who avoid relying on this simple heuristic are likely to perform as expected, on average similar to the overall market. I also find that underperformance is more severe for stocks that have doubled faster. The “doubling” variable is a significant predictor of future price reversals in addition to past performance per se, as uncovered by the previous researchers. Copyright © 2011 John Wiley & Sons, Ltd.