People are programmed to follow crowds because it helps our survival. If you see a crowd running in the same direction, you’re likely to follow it since “it must know something.” Doing so could save your life.
What about following the crowd when it comes to investing? Studies show the “wisdom of the crowds” becomes a liability in the investment world. This is true not only during bubble times, but during ordinary times, too.
During bubble times, extensive research underscores the wisdom of heading in the opposite direction when everyone is enthusiastic about something. Joseph Kennedy is said to have cashed out his stock market positions in 1929 when he heard a shoeshine boy giving stock tips. There are many similar stories – from tulip mania in the Netherlands to the 2001 Nasdaq crash. When everyone is excited about an investment, that’s a good sign to “get out early” and avoid running further with the crowds.
What Bubble?But more often than not, we’re not necessarily in the midst of a growing bubble. During these so-called “ordinary times,” data also indicate the crowd is more often wrong than right when it comes to investments. The Economist investigated Morningstar fund flow data and performance statistics in the US in order to determine if investor crowd wisdom paid off. Specifically, the Economist was looking to see if it paid off to invest money into something that already had done relatively well the previous year (something that already had a “good buzz.”) Looking at the most popular investment sector (that beat the average sector by more than 2 percentage points the previous year), the popular sector subsequently lagged the average by under 3 percentage points as investors continued to pour money it. Multiple test runs indicated the herd mentality was wrong approximately 60% of the time. 60% may not seem like a lot, but that’s hugely significant when compared with random statistical outcomes.
How about using “wisdom of the crowds” behavior as a contrarian indicator? The numbers seem to indicate that “pariah” or out of favor funds do better than popular sectors, but do not exceed average returns.
You’ve probably often heard the disclaimer “past performance is no guarantee of future performance” in mutual fund literature. Investment gurus frequently remark that past outperformance of mutual funds does not continue indefinitely due to mean reversion. In other words, an investment that did relatively well in the past likely will not continue to do so in the future. Investors typically get very enthusiastic about something after it’s done well, and end up “buying high, selling low.”
The reversion to the mean phenomenon can be seen as yet another reason to stick to “passive” (index-based) investing since data show it’s difficult to outperform a market on a consistent basis through active management. By some measures, approx. 75% of mutual funds who actively attempt to outperform a benchmark end up underperforming (doing less well).
Volumes have been written about these subjects so I’ll end here by touting portfolio diversification. Even pundits were skeptical after the 2008 crash about diversification since all assets fell together and there was no safe place to hide. However, diversification always reasserts itself and remains the cornerstone of prudent investing. Diversification simply means having exposure to many different assets classes (different types of bonds, different types of stocks, alternative investments) to smooth growth and lower volatility. The right mix of different assets is something your advisor can design for you. If you don’t have an investment advisor, there are some online tools that give you some ideas about ways to increase your diversification and simultaneously lower your risk.