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It may not surprise you to learn that our investing decisions are often the result of irrational behavior. But the findings of a new study suggest that many of our stock selections are systematically wrong-headed.
It turns out that the first letter of a company's name exerts undue influence on our investing behavior. Specifically, stocks starting with letters in the beginning of the alphabet are valued higher and traded more often than late-alphabet stocks, according to a November paper from business school researchers at Seton Hall and Yeshiva University.
"Back when people used phone books, they were more likely to choose companies with names like 'AAA Avocados' or 'Acme Pest Control' than those later in the alphabet," says Jesse Itzkowitz, a marketing professor at Yeshiva University’s Sy Syms School of Business. "The same is true today for retail investors reading through stock information they get from brokerages like Fidelity or TIAA-CREF."
That's because humans have a tendency to choose the first satisfactory option available, rather than taking extra time to make an optimal choice, says Itzkowitz.
The upshot of such "satisficing"? Stocks with early-alphabet names are traded 1.7% more often and are valued 6.1% higher by investors than late-alphabet companies, according to a measure that compares the underlying value of a business to its market price.
Other than knowing that this tendency artificially boosts the stocks of early-ABCs companies like Apple (and presumably inflicts a penalty on Zynga, for instance), what's the takeaway for investors who buy shares in individual companies?
For one, says Itzkowitz, be sure to sort through potential stock investments using valuation and fundamental metrics to narrow the options, rather than just reading through an alphabetical list.
"Human beings are able to expend only so much mental effort before making a decision, so it's best to focus on a manageable quantity of information," says Itzkowitz. (You can check out Money's advice on choosing stocks and play around with a free stock screener like the one at finviz.com.)
Perhaps more importantly, recognize that we all have limitations, and can all act irrationally, when it comes to choosing stocks. That's a case for letting professionals handle your money or—better yet—for investing in a passive index fund. That way you get you diversification without the risk of human error, since even experts make mistakes.