Buy this years Winners or Losers?

It’s that time of the year when you start finding analysts coming up with the Top stocks to buy. Basically there are three ways in which such lists are prepared – search for the best stocks of this year and recommend the same for the next year in anticipation of continuation of Momentum.

Search for the worst stocks and recommend the same for the next year in anticipation of a mean reversion or Recommend a random set of stocks and hope that something clicks.

Most investors on the other hand will rather buy a stock that is down 80% for the year than buy something that is up 80% for the year. It’s just a behavior trait. But how does buying a stock that was the best of last year pan out versus buying a stock that was the worst of last year.

Since 2010, the average gain of the best 100 stocks of the year has come to around 200%. On the other hand, the average loss of the worst 100 stocks of the year is about 60%. In other words, if you had created an equal weighted portfolio of the best stocks of the next year, your capital would be 3x what you started with while if you were unlucky and bought the worst 100, your capital would have gone down by 60%.

Do note that if you have a stock that has lost 60% from the time you bought it, it needs to move up by 150% for you to just break even. Other than in extreme bear markets such as 2008, more than 70% of the stocks that fell 60% or more never break-even or take years.

If you observe the data closely, you can see that the worst stocks of this year save for 2 years of the 9 years under consideration. While best stocks didn’t shine greatly, they did end up positive in 4 out of 9.

There is a very wrong belief that buying stocks that are going up is Momentum Investing. It is equivalent to saying that all beaten down stocks are value. Neither is True and the results above are proof of that.

Momentum is mean reverting. What this means is that if you hold a stock that is seeing strong momentum over an extended period of time, you are likely to take a hit since the stock generally sees reversal.

Take a look at the table below. Longer your holding period and higher the diversification (size of portfolio), lower is the return

Pic Source: https://amzn.to/2ZyUHfd

What would be interesting to research is whether buying a portfolio of the best stocks and holding for a short period of time works better. While trends tend to phase out over time, one month holding for the best stock of the past year should give out a better return than holding the same for one year.