Popularity is defined as the state of being liked, enjoyed or accepted by a large number of people. We come across a variety of items which are popular on a daily basis such as chocolates, holiday destinations, actors, electronic devices, television shows, fashion, perfume, cars, music, video games and others. The media plays a big role in making something popular. The criteria that determines popularity differs for each of the above items, and popularity changes over the course of time.

The theory of popularity plays an important role in the world of investing. The ‘most informed’ investor is the first one to get into an investment which is likely to get popular. As the popularity of the investment rises, its price also rises. The ‘average’ investor tends to get in once the price has gone up. Popularity is a key concept that explains the valuation of assets and their returns.

There are several asset classes in the financial universe, but the key asset classes are cash, bonds, stocks, and alternative assets (real estate, commodities, private equity, etc.). Whatever the asset class line-up is, each asset is expected to reflect different risk and return characteristics, and will perform differently in any given market environment.

Bonds are expected to have higher returns than cash because bonds are riskier than cash. The excess returns of stocks over bonds are due to the fact that stocks are riskier than bonds. The same explanation holds for the higher returns on alternative investments over stocks. In turn, investors demand a premium for taking investment risk. There is some correlation between risk and popularity.

Securities within an asset class may perform differently than the asset class itself. The higher popularity of large cap stocks compared to small cap stocks is a good example. Market capitalisation of a stock is a contributing factor towards its popularity. The most popular stocks are normally the popular brand names.

These stocks enjoy good analysis, media coverage and high trading volumes. The share turnover (volume traded relative to the outstanding number of shares) is a good measure of popularity. Companies with high share price resort to stock splits to make the shares attractive and affordable to the wider investment community. Stock splits may increase a stock’s popularity. Recent examples are Apple and Netflix stock splits.

Besides risk, liquidity impacts popularity. The size and trading volume of a security have a bearing on its liquidity. Investors prefer liquidity, and so they demand higher compensation for lower liquidity. The high liquidity of government bonds compared to corporate bonds explains the popularity of government bonds.

Within the government bond market, on-the-run bonds (most recent issues) are more popular than off-the-run bonds; hence on-the-run bonds have lower yields than off-the-run bonds as seen in US Treasuries. For a given expected return, investors prefer high liquidity.

Momentum also impacts popularity and returns. Investors chasing momentum keep buying a security while its price is going higher. The herd instinct also adds to price rise and popularity. However, accelerating price is more likely to undergo corrections as the momentum may not be sustained, thereby generating return lower than initially anticipated. The tech bubble and the mortgage debt crisis are perfect examples of this.

The more popular an asset becomes, the more expensive its valuation tends to become. The more expensive an asset is, the less likely that its return will be higher. In a market environment where the majority of investors are buying more popular assets, buying less popular assets will be like swimming against the tide.

To achieve higher returns, investors need to go against the crowd by buying the less popular assets. If an investor holds unpopular stocks and they become popular, that would in fact be the best case scenario.

The popularity of assets can differ from market to market and from region to region. For example assets that are most popular with Middle Eastern investors may not be popular with European investors.

Popularity contributes to mispricing of securities. The popularity of securities that the market likes too much may be short-lived. Similarly the popularity of securities that the market likes too little also may be short-lived. This is because the mispricing of the security will soon be spotted by investors and so the mispricing tends to get corrected.

Investors can’t ignore popularity in investment decisions.

— Tholoor Mathew Thomas is a former member of CFA Society Bahrain and Mahmoud Nawar is president of CFA Society Bahrain