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Investing in stocks priced under $100 can be enticing due to their potential for substantial gains. However, these stocks often carry higher risks compared to their higher-priced counterparts.
Academic research has delved into various aspects of this segment of the stock market, offering insights into why these investments may be more volatile, less liquid, and subject to mispricing. This article will explore these risks in detail, supported by key academic studies.
Volatility and Risk
Volatility is a critical concern for investors in lower-priced stocks. These stocks often belong to smaller companies with less established market positions, making them more susceptible to significant price swings.
The seminal work by Fama and French (1992) on the cross-section of expected stock returns highlights that smaller firms, which frequently have lower-priced stocks, tend to exhibit higher returns. However, this comes at the cost of increased risk.
The study identifies a strong relationship between firm size and return volatility, where smaller firms are more prone to market fluctuations, economic downturns, and changes in investor sentiment.
This increased volatility can lead to substantial short-term losses for investors, particularly in bear markets or during periods of economic uncertainty. The potential for outsized gains is appealing, but the corresponding risk of sharp declines must be carefully considered. Investors must weigh their risk tolerance against the possibility of high volatility when investing in stocks priced under $100.
Liquidity Concerns
Liquidity, or the ease with which an asset can be bought or sold in the market without affecting its price, is another significant risk factor associated with lower-priced stocks.
Amihud and Mendelson’s (1986) research on asset pricing and the bid-ask spread provides a comprehensive analysis of how liquidity impacts asset prices.
The study suggests that less liquid stocks, which are more common among lower-priced shares, often command a liquidity premium. This premium compensates investors for the additional risk they bear due to the difficulty of trading these stocks.
Lower liquidity in stocks priced under $100 can lead to wider bid-ask spreads, making it more expensive to enter or exit positions. Additionally, lower trading volumes can exacerbate price swings, as even relatively small trades can significantly impact the stock price. This liquidity risk can result in higher transaction costs and increased difficulty in executing trades, particularly during times of market stress.
Market Anomalies and Mispricing
Market anomalies and the potential for mispricing are also prevalent in lower-priced stocks.
Lakonishok, Shleifer, and Vishny’s (1994) study on contrarian investment strategies sheds light on the mispricing that can occur in this segment of the market.
The research suggests that lower-priced stocks, often representing smaller companies or those in financial distress, are more likely to be mispriced due to behavioural biases, such as overreaction to news or speculative trading.
This mispricing can create opportunities for savvy investors, but it also introduces significant risk. Stocks may be undervalued or overvalued based on short-term market sentiments rather than their fundamental value.
This disconnect between market price and intrinsic value can lead to abrupt price corrections, posing a risk to investors who do not have a deep understanding of the underlying company’s fundamentals.
Behavioural Factors
Behavioural finance offers additional insights into the risks associated with investing in lower-priced stocks.
Barberis and Thaler (2003) explore how cognitive biases influence investor behaviour, particularly in the context of speculative stocks.
Their research highlights how investors are often driven by overconfidence, the illusion of control, and the gambler’s fallacy, which can lead to irrational buying and selling decisions.
These behavioural biases are more pronounced in lower-priced stocks, where the allure of quick gains can overshadow rational analysis.
For example, investors may be drawn to these stocks based on past performance or the perception that a low price indicates a "bargain," without fully considering the company’s financial health or future prospects.
This can lead to herd behaviour, where large numbers of investors move in and out of positions based on trends rather than fundamentals, further increasing volatility and risk.
Conclusion
Investing in stocks priced under $100 presents a unique set of challenges that require careful consideration. While the potential for significant returns is real, the risks are equally substantial. Higher volatility, liquidity concerns, market mispricing, and behavioural biases all contribute to the complexity of investing in this segment of the market.
Academic research provides valuable insights into these risks, helping investors to make more informed decisions. By understanding the underlying factors that drive the performance of lower-priced stocks, investors can better assess whether these investments align with their risk tolerance and financial goals.
Ultimately, while stocks under $100 can be part of a diversified portfolio, they should be approached with caution and a clear strategy. Diversification, thorough research, and a disciplined investment approach are essential to managing the risks associated with these potentially volatile investments.
References:
- Fama, E. F., & French, K. R. (1992). The Cross-Section of Expected Stock Returns. Journal of Finance, 47(2), 427-465.
- Amihud, Y., & Mendelson, H. (1986). Asset Pricing and the Bid-Ask Spread. Journal of Financial Economics, 17(2), 223-249.
- Lakonishok, J., Shleifer, A., & Vishny, R. W. (1994). Contrarian Investment, Extrapolation, and Risk. Journal of Finance, 49(5), 1541-1578.
- Barberis, N., & Thaler, R. (2003). A Survey of Behavioral Finance. Handbook of the Economics of Finance, 1, 1053-1128.
Alpesh Patel OBE
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Disclaimer: The content provided on this blog is for informational purposes only and does not constitute financial advice. The opinions expressed here are the author's own and do not reflect the views of any associated companies. Investing in financial markets involves risk, including the potential loss of your invested capital. Past performance is not indicative of future results.
You should not invest money that you cannot afford to lose. Mentions of specific securities, investment strategies, or financial products do not constitute an endorsement or recommendation. The author may hold positions in the securities discussed, but these should not be viewed as personalised investment advice.
Readers are encouraged to conduct their own research and seek professional advice before acting on any information provided in this blog. The author is not responsible for any investment decisions made based on the content of this blog.
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