Double then Nothing: Why Individual Stock Investments Disappoint

Abstract

Why are many often disappointed by investments in stocks, particularly those with attractive track records of increasing stock prices, and to what extent is individual stock return predictability overlooked when make their investment decisions? We compare two groups of solely on the basis of the types of stocks in which they invest: we assume rational or fundamentalists, are not concerned with recent stock price history while irrational or investors rely solely on whether a stock's price has recently doubled, e.g., within the past four years. We show that, over the subsequent four years, only the irrational noise are disappointed with their investments, with a cumulative excess return of -28% versus near-zero for the fundamentalists. Much of the cross-sectional variation in investment period returns can be explained not only by investment period market returns (a positive relationship) but also past stock performance (negative), past earnings (positive), and various valuation-related metrics measured at the start of the investment period. A probit model identifies ex ante variables that are able to predict whether or not a stock will at least double in value over the investment period. Investing in stocks with a high (ex ante) probability of leads to annualized excess returns of 11%-20% greater than investing in stocks with a low probability of doubling. Finally, we show that a doubling portfolio (made up of stocks that have recently doubled in price) is quite different from the seminal DeBondt and Thaler (1985) winner portfolio and yet displays just as strong a reversal effect.