The Risk in Stocks of Fast Growing Companies
A fast-growing stock – what clients believe is the next Google – is likely to be a disappointing investment. New research, which validates the theory of behavioral economics, shows that “representativeness” explains why clients overweight stocks with high asset growth.
Investing is more about uncertainty (where at best we can estimate the odds of something occurring) than risk (where the odds are known, like at the craps table). When faced with uncertainty while trying to make a decision, people often rely on a mental shortcut known as the “representativeness heuristic” – a simplified approach to problem-solving using judgments arrived at by comparing things to concepts we already have in mind.
In the 1970s, psychologists Amos Tversky and Daniel Kahneman proposed that the representativeness heuristic explains behaviors that lead to mistakes – when people rely on representativeness to make judgments, they are likely to judge wrongly because the fact that something is more representative does not actually make it more likely. In addition, research demonstrates that people overestimate their ability to accurately predict the likelihood of an event.
Miao He, Nishad Kapadia and Sheri Tice contribute to the literature with their August 2020 study, “Can the Representativeness Heuristic Explain the Asset Growth Anomaly?” They began by noting that the low average returns of firms with high asset growth are now well documented. The investment factor (CMA), the return on stocks with low/conservative investment minus the return on stocks with high/aggressive investment, is now incorporated into both the Fama-French five-factor and the Hou, Xue and Zhang q-factor models. The logic for the premium is that asset growth reflects investment and firms that can invest a lot, all else equal, should have low discount rates. However, they noted that “asset growth is not a particularly good measure of investment and better measures do not share its effects on returns. A natural question that arises is what causes high asset growth stocks to have low returns?”