This content is from: Opinion

Themes, Memes, and Shiny Things

A reminder that salience bias is influencing the decisions investors make.

In European folklore, magpies, the colorful birds recognized for their intellect, love to steal jewelry and trinkets, winging away with the shiny baubles as decorations for their nests. The belief goes that, although the sparkly objects have no real intrinsic value to the birds, they just can’t help themselves. Glitz and glitter capture their attention.

Whether or not this tale is true, we humans do have a tendency towards similar behavior. We often focus our attention on particularly notable or prominent characteristics of things, whether those characteristics are important or not. 

It’s called the salience bias, and it’s a well-documented psychological phenomenon related to how we go about processing probabilities. We quickly focus our attention on headline-grabbing news and other things that stand out from their surroundings. Since we have limited processing power, we naturally give these conspicuous features of our environment priority and focus on them.

Salience bias has been shown to significantly influence people’s perception of the causes and frequencies of events. For instance, media coverage that sensationalizes relatively unusual events causes people to massively overestimate the frequency of less common dangers, such as airplane crashes, and underestimate much more widespread threats that do not get as much press, for instance, colon cancer.

This heuristic wasn’t so damaging to our ancestors, who scanned the horizon for signs of anything out of ordinary as their family troop searched for food. But in the modern knowledge-based economy, this unconscious bias is far more distracting, and even harmful, as we face an endless overload of information and data.

Research by behavioral finance gurus Brad Barber and Terrance Odean has shown that retail investors demonstrate a predictable — and damaging — tendency to buy stocks that have been recently featured in the news. Using data from 78,000 accounts at a large discount brokerage firm, the researchers showed that people were far more likely to buy stocks after a big one-day return or other headline making event had caught their attention. Not only that, but the more actively individual investors scooped up these attention-grabbing stocks, the worse they performed. 

Further research from economists Werner Antweiler and Murray Frank revealed a similar phenomenon looking at internet message board activity. Sorting through nearly 35 million messages posted to Yahoo! Finance from 1999 to 2001, the authors found that the stocks with the highest levels of posting activity exhibited higher trading volumes, unusual volatility, and poor subsequent returns, even when controlling for a host of other characteristics. Once again, the investors who were wowed by headlines and frenetic message activity did worse than average and underperformed the broader market.

Over the last few years, meme stocks — companies that have rapidly gained popularity through social media platforms like Reddit — have become all the rage with retail investors and surged in price. Despite the skyrocketing valuations for these stocks — businesses like GameStop (GME) and AMC Entertainment (AMC) — these rapid gains are usually generated by the abnormal buying pressure from herd-chasing investors piling in, not improving business fundamentals. 

Quite often the contrary holds true; many of these companies that have been in the news have suffered from deteriorating business conditions. And, unfortunately for investors, that initial price surge has been followed once again by massive volatility and subsequent price declines. 

History is repeating itself, it's the internet message board phenomena all over again!

Never one to miss out on a demand boom, Wall Street has gotten in on the meme action with the launch of hundreds of thematic ETFs. These specialty ETFs are tradable funds that offer investors an easy and convenient way to invest in a specific theme or trend, such as artificial intelligence, blockchain, cybersecurity, or climate change. Unfortunately, a recent paper on the performance of these thematic ETFs is less than encouraging.

Recent research from the Swiss Finance Institute comparing the returns of specialized ETFS (thematic) with that of broad-based ETFs (that track indices) highlighted that within the first five years of the fund life, thematic ETFs go on to underperform the market by about 30 percent on average. Further, this difference in returns couldn’t be explained by higher fees or differences in risk; rather, the researchers argued that the underperformance is driven by the initial overvaluation of the underlying theme stocks at launch. 

Even Research Affiliates has published a current missive suggesting that meme-driven cryptocurrencies have significantly more risk than those with a true potential for disruption, like Bitcoin or Ethereum.

The financial industry — old school and new school alike — sells what’s hot when it’s the hottest. Although history shows that’s the worst time to buy, we just can’t help ourselves.

Not coincidentally, I just read an article stating that Warren Buffet has once again risen to the ranks of the top five investors in the world. Despite the volatility in equity markets, shares of Berkshire Hathaway are up roughly 7.5 percent so far year to date, not on the back of popular themes, but by owning solid businesses in industries like transportation, consumer products, and energy. 

In investing, it often pays to ignore what Carl Sagan called our reptilian brain (or for this article, our bird brain!). If we can manage to pull our attention away from all the shiny things Wall Street puts in front of us, as difficult as it might be, and focus on what matters — like earnings quality, valuation, dividend yield and real growth — investors will likely find better odds of long-term success.

And that’s better than alpha.

Chris Schelling is the chief investment strategist and director of alternatives at Venturi Private Wealth, an Austin, Texas-based RIA. He was previously a managing director at Windmuehle Funds, a boutique investment firm, and the director of private equity at the $30 billion Texas Municipal Retirement System. Before that, he was the deputy chief investment officer and director of absolute return at the $15 billion Kentucky Retirement Systems.