When a company first goes public on the stock exchange, the corresponding securities are known as IPO (initial public offering) shares. These shares typically exhibit below-average returns for the initial years following the offering, except for a few outliers that surge in value right from the start. In other words, the likelihood of achieving high returns is relatively low. Why, then, do people still purchase IPO shares? The reason is their tendency to overestimate the probability of the stock becoming one of the rare super performers. This phenomenon is explained by prospect theory, a leading theory that elucidates decision-making under uncertainty. This is akin to why people buy lottery tickets: they hope to hit the jackpot.
Some investments yield a very different distribution of profits and losses, usually characterised by a high likelihood of small returns. This is the standard scenario. Conversely, significant losses are improbable, such as with catastrophe bonds or “cat bonds”. Insurance companies use these bonds to create a financial cushion to guarantee coverage in a disaster. If nothing happens, investors receive a series of small payouts. However, all the invested money is lost in the statistically unlikely event of a natural disaster.
What circumstances influence how people select a particular type of security in the first place? Dr. Sebastian Olschewski from the Faculty of Psychology has published a study on this topic in the journal PNAS. In the experiment, participants were asked to choose between two or three different stocks, for example, one offering “a low probability of high returns” and another offering “a high probability of modest returns with rare but potentially high losses”. To aid in the decision-making process, information was provided about the performance of the stocks, i.e., when and what returns were generated by the specific stocks on day 1, day 2, day 3, etc. This allowed participants to closely examine the volume and frequency of each stock’s returns.
The results showed that the ability to compare different stock types significantly influences a person’s decision, favouring investments on the cat bond end of the spectrum. “In our experiment, the participants selected stocks that generated the highest returns on the greatest number of days. The overall total of the returns had only an ancillary effect.” This is what experts refer to as the “frequent winner effect”. To demonstrate the significance of this effect, the data on stock returns was modified in a second experimental design so that the “lottery-like” investments more frequently showed higher yields, quickly shifting participants’ preference towards this type of stock.
What conclusions can be drawn from the study? “If we want to predict how the stock market will perform, we also need to consider how people go about finding information,” says Olschewski. “Whether they simply research a single stock or compare two or three options.” Predicting such behaviour is crucial for economists or analysts who aim to forecast price trends in the stock market. It is also essential for social resource planning, such as governments investing to benefit their citizens. For example, the Swiss pension system is partially funded in the capital market, as Olschewski points out.
More information: Sebastian Olschewski et al, Frequent winners explain apparent skewness preferences in experience-based decisions, Proceedings of the National Academy of Sciences. DOI: 10.1073/pnas.2317751121
Journal information: Proceedings of the National Academy of Sciences Provided by University of Basel