Irrational Momentum Behind Stocks, Real Estate and Fads

It's no secret that momentum is a powerful force in the stock market. It can drive real estate prices too, and may even account for all those color-coded rubber wristbands everyone is wearing today.

Problem is, momentum is often irrational, and advertisers know it.

In a new study, people were asked to buy and sell virtual stocks that had long histories of either increasing or decreasing earnings. For the most part, folks bought winners and sold losers.

If that result doesn't surprise you, then you're just the sort of investor that Joseph Johnson University of Miami wants to warn.

"This behavior violates the normative rule of buy low and sell high," Johnson says.

"Much of financial research concludes that past runs of information such as earnings are really not a good predictor of the future prospects of a stock," Johnson told LiveScience. "Yet people persist in using these runs as predictors of future success or failure."

When things get out of hand, analysts refer to it as "irrational exuberance," a term coined by Federal Reserve Board Chairman Alan Greenspan in a 1996 speech discussing "unduly escalated asset values."

Anyone promoting a stock is required by the SEC to mention that past performance does not guarantee future prospects. Still, "advertisers rightly suspect that consumers use such information to make buy decisions," Johnson and his colleagues argue in the September issue of the Journal of Consumer Research.

"Thus, the SEC needs to investigate whether the current disclosure serves any useful purpose and what alternative form it should take," they write.

The new study, with conclusions similar to previous research, may have broader implications.

The results "may explain the hype that surrounds the rapid growth of new products, the escalation in real estate prices in a hot market, and the rise of fads," the scientists write.

Advertisers know all this, Johnson's team says, and it makes it easier for them "to negatively take advantage of consumers."