The use of the recognition heuristic as an investment strategy in European stockmarkets

Júlio Lobão, Luís Pacheco, Carlos Pereira

Abstract


Purpose – People often face constraints such as a lack of time or information in taking decisions, which leads them to use heuristics. In these situations, fast and frugal rules may be useful for making adaptive decisions with fewer resources, even if it leads to suboptimal choices. When applied to financial markets, the recognition heuristic predicts that investors acquire the stocks that they are aware of, thereby inflating the price of the most recognized stocks. This paper aims to study the profitability against the market of the most recognized stocks in Europe.

Design/methodology/approach – In this paper, the authors perform a survey and use Google Trends to study the profitability against the market of the most recognized stocks in Europe.

Findings – The authors conclude that a recognition heuristic portfolio yields poorer returns than a market portfolio. In contrast, from the data collected on Google Trends, weak evidence was found that strong increases in companies monthly search volumes may lead to abnormal returns in the followingmonth.

Research limitations/implications – The applied investment strategy does not account for transaction costs, which may jeopardize its profitability given the fact that it is necessary to revise the portfolio on a monthly basis. Despite the results obtained, they are useful to understanding the performance of recognition heuristic strategies over a comprehensive time horizon, and it would be interesting to depict its
viability during different market conditions. This analysis could provide additional information about a preferable scenario for employing our strategies and, ultimately, enhance the profitability of recognition
heuristic strategies.

Practical implications – Through the exhaustive analysis performed here on the recognition heuristic in the European stock market, it is possible to conclude that no evidence was found for the viability of exploring
this type of strategy. In fact, the investors would always gain better returns when adopting a passive investment strategy. Therefore, it would be wise to assume that the European market presents at least a degree of efficiency where no investment would yield abnormal returns following the recognition heuristic.

Originality/value– The main objective of this paper is to study the performance of the recognition heuristic in the financial markets and to contribute to the knowledge in this field. Although many authors have already studied this heuristic when applied to financial markets, there is a lack of consensus in the literature.


Keywords


Investment decisions; behavioural finance; stock returns; financial market; recognition heuristic

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