Below is a short explanation why software and financial service firms seem to have outperformed the other industrial sectors over time and might be, on average, better investments than some other sectors.
It is based on the observation that both sectors produce invisible products in the sense that they only produce, store and move information which has no physical shape in itself. With some reflection on the matter, one can convince oneself that the costs associated with storing and moving information are much lower than those associated with storing and moving "real world" objects. For instance, sending an email seems to be much cheaper than sending anything - be it a letter or candies - by mail.
Now, the common sense will also tell us that if a sector has much lower costs compared to others, its profits are bound to be higher in the long run since profits are revenues minus costs.
This is exactly the story that the numbers tell us. To quantify this effect, look at the Price-to-Book (P/B), Price-to-Earnings (P/E), and Net Profit Margins of the financial services companies vis-a-vis to other industries (see References below). Interestingly, Financial Services seem to have the lowest P/B and P/E ratios (indicating that they are relatively undervalued) while also having the highest net profit margins compared to other sectors.
Also, notice that the financial services industry has the highest combined market cap of all sectors (see References below), indicating they have exhibited the highest growth rates over history, for to grow to be the largest, they must have. Mind you that, money and banks as such were relatively late invention in human history compared to some other activities such as agriculture. And if you think banking - the business of trading trust in a standardised manner - is not novel, you must agree that innovations such as financial securities and derivative instruments are little newer than many of the other everyday activities we perform.
The story with software companies is not as clear since they have a higher failure rate and higher sales costs, espcially in the enterprise software market, but they do share one thing in common with financial services firms - they only produce, move and store information, and no physical objects.
What is the significance of this finding? In short, it is that if you invest in the stock market, you are better off holding more rather than less stock in the financial services companies.
But why would people, on average, still prefer to invest more in non-financial - or what can be "brick-and-mortar" - companies despite the relatively low earnings compared to the stock prices of these companies, as indicated by high P/E and P/B ratios? Because such companies produce "visible" products, or "household-name brands", and we are psychologically more inclined to invest in companies that produce things that we see, understand and can easily identify with. Such things include cars, energy, and retail goods that are constantly visible in our everyday experience. In contrast, fewer people understand what, say, investment banks do, nor can a retail investor from the street easily identify with what they "produce". As a result, one could argue the stock price performance of such companies tends to have an "invisibility premium" over time.
References
Yahoo Sector Browser
Monday 12 June 2006
Pronouncability Arbitrage
Three studies investigated the impact of the psychological principle of fluency -- that people tend to prefer easily processed information -- on short term share price movements. In both a laboratory study and an analysis of naturalistic real world stock market data, fluently named stocks robustly outperformed stocks with disfluent names in the short term. For example, in one study, an initial investment of $1000 yielded a profit of $112 more after one day of trading for a basket of fluently named shares than for a basket of disfluently named shares. These results imply that simple, cognitive approaches to modeling human behavior sometimes outperform more typical, complex alternatives.
The ease of pronouncing the name of a company and its stock ticker symbol influences how well that stock performs in the days immediately after its initial public offering, two Princeton University psychologists have found.
A new study of initial public offerings (IPOs) on two major American stock exchanges shows that people are more likely to purchase newly offered stocks that have easily pronounced names than those that do not, according to Princeton's Adam Alter and Danny Oppenheimer. The effect extends to the ease with which the stock's ticker code, generally a few letters long, can be pronounced -- indicating that, all else being equal, a stock with the symbol BAL should outperform one with the symbol BDL in the first few days of trading.
"This research shows that people take mental shortcuts, even when it comes to their investments, when it would seem that they would want to be most rational," said Oppenheimer, an assistant professor of psychology. "These findings contribute to the notion that psychology has a great deal to contribute to economic theory"
Oppenheimer and Alter, a graduate student in Oppenheimer's lab and the study's lead author, will publish their work in the May 30 issue of the journal, Proceedings of the National Academy of Sciences.
The two researchers were initially looking for a different effect when they stumbled upon the relationship between ease of pronounceability and performance. They asked a group of students to estimate how well a series of fabricated stocks would perform based only on the stocks' names.
"We gave them the list of company names and essentially asked, 'How well do you think the stock would perform?'" Oppenheimer said. "At the time, we were primarily interested in studying whether we could manipulate how people interpret the feeling that information is easy to process. We weren't trying to study markets or companies initially; stocks were just an interesting domain of inquiry."
However, the relationship was very strong -- regardless of Alter and Oppenheimer's attempts to manipulate students' interpretations, the students still believed that the easily pronounceable stocks would perform best.
When they noticed how strongly name pronounceability influenced predictions of performance, the researchers moved beyond the lab and investigated the relationship between the variables in two large US stock markets--the New York Stock Exchange and the American Exchange. The effect held in the real world: the more "fluent" a stock's name or symbol, the more likely the stock was to perform well initially.
"We looked at intervals of a day, a week, six months and a year after IPO," Alter said. "The effect was strongest shortly after IPO. For example, if you started with $1,000 and invested it in companies with the 10 most fluent names, you would earn $333 more than you would have had you invested in the 10 with the least fluent."
Alter said the pair of scientists had been careful to address the possibility that other factors were at play in the study.
"We thought it was possible that larger companies might both adopt more fluent names and attract greater investment than smaller companies," he said. "But the effect held regardless of company size. We also showed that the effect held when we controlled for the influence of industry, country of origin, and other factors."
Oppenheimer cautioned that while the findings might seem highly significant to the investing public, they do not tell the whole story about how a stock might perform after its IPO, nor are they reliable indicators of its performance in the long run.
"Despite the implications of these findings, investors as a group tend to correct themselves in the presence of new information about how the markets operate," he said. "You shouldn't make changes to your stock portfolio based on our findings. The primary contribution of this paper is to add a piece to the jigsaw of understanding how markets operate."
What the findings did offer, Oppenheimer said, was another piece of evidence that markets -- and therefore the large groups of people who invest in them -- are not the rationally-functioning entities that some experts believe them to be.
"This is not the only factor that plays a role in stock performance," he said. "A number of other economic and psychological factors undoubtedly play a role as well. This study does not argue that psychology is more important than economics, but rather that one cannot ignore psychological variables when constructing models of stock performance."
References
Predicting Short-Term Stock Fluctuations by Using Processing Fluency
The ease of pronouncing the name of a company and its stock ticker symbol influences how well that stock performs in the days immediately after its initial public offering, two Princeton University psychologists have found.
A new study of initial public offerings (IPOs) on two major American stock exchanges shows that people are more likely to purchase newly offered stocks that have easily pronounced names than those that do not, according to Princeton's Adam Alter and Danny Oppenheimer. The effect extends to the ease with which the stock's ticker code, generally a few letters long, can be pronounced -- indicating that, all else being equal, a stock with the symbol BAL should outperform one with the symbol BDL in the first few days of trading.
"This research shows that people take mental shortcuts, even when it comes to their investments, when it would seem that they would want to be most rational," said Oppenheimer, an assistant professor of psychology. "These findings contribute to the notion that psychology has a great deal to contribute to economic theory"
Oppenheimer and Alter, a graduate student in Oppenheimer's lab and the study's lead author, will publish their work in the May 30 issue of the journal, Proceedings of the National Academy of Sciences.
The two researchers were initially looking for a different effect when they stumbled upon the relationship between ease of pronounceability and performance. They asked a group of students to estimate how well a series of fabricated stocks would perform based only on the stocks' names.
"We gave them the list of company names and essentially asked, 'How well do you think the stock would perform?'" Oppenheimer said. "At the time, we were primarily interested in studying whether we could manipulate how people interpret the feeling that information is easy to process. We weren't trying to study markets or companies initially; stocks were just an interesting domain of inquiry."
However, the relationship was very strong -- regardless of Alter and Oppenheimer's attempts to manipulate students' interpretations, the students still believed that the easily pronounceable stocks would perform best.
When they noticed how strongly name pronounceability influenced predictions of performance, the researchers moved beyond the lab and investigated the relationship between the variables in two large US stock markets--the New York Stock Exchange and the American Exchange. The effect held in the real world: the more "fluent" a stock's name or symbol, the more likely the stock was to perform well initially.
"We looked at intervals of a day, a week, six months and a year after IPO," Alter said. "The effect was strongest shortly after IPO. For example, if you started with $1,000 and invested it in companies with the 10 most fluent names, you would earn $333 more than you would have had you invested in the 10 with the least fluent."
Alter said the pair of scientists had been careful to address the possibility that other factors were at play in the study.
"We thought it was possible that larger companies might both adopt more fluent names and attract greater investment than smaller companies," he said. "But the effect held regardless of company size. We also showed that the effect held when we controlled for the influence of industry, country of origin, and other factors."
Oppenheimer cautioned that while the findings might seem highly significant to the investing public, they do not tell the whole story about how a stock might perform after its IPO, nor are they reliable indicators of its performance in the long run.
"Despite the implications of these findings, investors as a group tend to correct themselves in the presence of new information about how the markets operate," he said. "You shouldn't make changes to your stock portfolio based on our findings. The primary contribution of this paper is to add a piece to the jigsaw of understanding how markets operate."
What the findings did offer, Oppenheimer said, was another piece of evidence that markets -- and therefore the large groups of people who invest in them -- are not the rationally-functioning entities that some experts believe them to be.
"This is not the only factor that plays a role in stock performance," he said. "A number of other economic and psychological factors undoubtedly play a role as well. This study does not argue that psychology is more important than economics, but rather that one cannot ignore psychological variables when constructing models of stock performance."
References
Predicting Short-Term Stock Fluctuations by Using Processing Fluency
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