How comparison options affect stock buys

When a company first goes public on the stock exchange, the corresponding securities are referred to as IPO (initial public offering) shares. These shares are typically characterized by their below-average returns for the first few years after the initial offering – with the exception of a few outliers that boom right from the start. In other words, the likelihood of high returns is rather small. 

So why do people still purchase IPO shares? Because they overestimate the probability of the stock becoming one of the rare super performers. This phenomenon is described by prospect theory, the leading theory used to explain decision-making in the face of uncertainty. It’s a similar story when people purchase lottery tickets: they are hoping to hit the jackpot.

There are also investments that result in a much different distribution of profits and losses, with a high likelihood of small returns. This is the standard case, so to speak. On the other hand, big losses are unlikely, such as with catastrophe bonds, or “cat bonds”. Insurance companies use these bonds to create a financial cushion that enables them to guarantee coverage in the event of a disaster. If nothing happens, investors receive a series of small payouts. In the statistically unlikely event of a natural disaster, however, all of the money they have invested is lost.

Then what stocks should I pick?

What circumstances affect how people select a given type of security in the first place? Dr. Sebastian Olschewski from the Faculty of Psychology has published a study on the topic in the journal PNAS.

In the experiment, test subjects 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 test subjects to closely examine the volume and frequency of the returns from each individual stock.

Frequent returns preferred

The results showed that having the possibility to compare different stock types greatly affects a person’s decision – and in a way that favors investments on the cat bond end of the spectrum. “In our experiment, the test subjects 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”.