Double then Nothing: Why Individual Stock Investments Disappoint

48 Pages Posted: 22 Mar 2008 Last revised: 11 Dec 2011

See all articles by Stephen R. Foerster

Stephen R. Foerster

University of Western Ontario - Richard Ivey School of Business

Date Written: March 3, 2009

Abstract

Why are many investors 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 investors make their investment decisions? We compare two groups of investors solely on the basis of the types of stocks in which they invest: we assume rational investors or "fundamentalists," are not concerned with recent stock price history while irrational investors or "noise 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 investors 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 doubling 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.

Keywords: behavioral finance, overreaction, predictability, valuation, stock investments, survivorship bias

JEL Classification: G11, G12, G14

Suggested Citation

Foerster, Stephen R., Double then Nothing: Why Individual Stock Investments Disappoint (March 3, 2009). Available at SSRN: https://ssrn.com/abstract=1104729 or http://dx.doi.org/10.2139/ssrn.1104729

Stephen R. Foerster (Contact Author)

University of Western Ontario - Richard Ivey School of Business ( email )

1255 Western Road
London, Ontario N6G 0N1
Canada
519-661-3726 (Phone)
519-661-3485 (Fax)

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