Do you feel the urge to sell if a company reached a 52-week (one year), or all-time high?
Let me ask the question the other way around.
Do you hesitate to invest if a company is at its 52-week or all-time high?
You are not alone
If you do you are not alone. This is because market commentators use a lot of ratios and other metrics that give you an emotional response.
A company’s stock price reaching or exceeding a 52-week high is a good example. It is a widely reported and easily noticed (on a chart) statistic. This may give you the idea that it is valuable information you should be paying attention to.
But psychological studies have shown that we wrongly place too much importance on facts that stand out, look important, and are easily recalled.
Like a shark attack
A recent shark attack, for example, will lead you to overestimate the likelihood that you will be attacked by a shark even if it is more likely that you will be killed by lightning or an asteroid.
Back to the 52-week high
But how can a company’s stock price reaching a 52-week high make you do something wrong?
In an interesting research paper called Psychological Barriers, Expectational Errors, and Underreaction to News Justin Birru (Ohio State University - Department of Finance) proved that stock prices are at a 52-week high,creates a psychological barrier beyond which investors think they are unlikely to go.
Price can’t go higher
Investors ignore the possibility that the stock price can go higher, which leads them to sell.
When a stock price reaches a 52-week high you may be telling yourself:
“This stock price is up a lot. I must sell now because the price is high compared to where it has been over the past year and it may fall.”
It is as if your mind only looks back over the past year from the current 52-week high but cannot imagine stock prices outside this 52-week period.
This may lead you to think it’s not possible that the stock prices may move outside these values (higher than the 52-week high). This leads you to sell your investment.
You ignore valuation
You are so focused on this 52-week high price barrier that you ignore other factors such as the company’s valuation.
This is also why you have doubts about buying a company, with its stock price at a 52-week high.
Getting back to the research paper.
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Measuring pessimism
In the paper, to measure if investors really are pessimistic about a stock price increasing above its 52-week high, Justin looked at what happens when companies announce results.
The evidence
He found strong evidence that investors became overly pessimistic about the results of companies when its stock price was near a 52-week high, since they were very surprised by better than expected results.
When companies with stock prices close to their 52-week high had positive earnings surprises (better than expected results) they had larger stock price increases compared to companies not close to their 52-week high.
How can this help you?
How can this information help you?
If one of your investments is close to a 52-week high you shouldn’t be worried. In fact, you should be glad, as it means the price most likely will go higher.
Also, if a company that fits your investment strategy, is close to a 52-week high, or even all-time high, don’t hesitate to buy as the stock price has a big chance of going higher.
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