The Un-Wisdom of Crowds

Submitted by Eve Kaplan on Tuesday, March 6, 2012 - 9:00am
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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 the crowd since it must know something. Doing so could save your life. But don’t do it as an investor.
 
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, as well.
 
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 in the 1600s 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.
 
But more often than not, we’re not in the midst of a growing bubble. During these so-called ordinary times, data also indicates the crowd is more likely wrong when it comes to investments.
 
The Economist magazine investigated Morningstar fund flow data and performance statistics in the U.S. to determine if investor crowd wisdom paid off. Specifically, the Economist was looking to see if it was worthwhile to invest money into something that had already done relatively well the previous year.
 
The magazine focused on the most popular investment sector, one that beat the average sector by more than two percentage points the previous year. The popular sector subsequently lagged the average by under three percentage points, even as investors continued to pour money into it. Multiple test runs indicated the herd mentality was wrong approximately 60% of the time. 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, mutual funds do better than popular sectors, but do not exceed average returns.
 
You’ve probably often heard the disclaimer in mutual fund literature: “past performance is no guarantee of future performance.” 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, and later selling low when its price and popularity fade.
 
The reversion to the mean phenomenon can be seen as yet another reason to stick to passive, namely index-based, investing. Data show it’s difficult to outperform a market on a consistent basis through active management. By some measures, 75% of actively managed mutual funds – meaning their managers attempt to outperform a benchmark by picking stocks they think will be winners -- end up underperforming the benchmark.
 
What’s the smartest way to invest? Portfolio diversification. Many pundits were skeptical after the 2008 crash about diversification since almost all assets fell together, from stocks to bonds to commodities. There was no safe place to hide then, other than low-yielding Treasury bonds. However, diversification always reasserts itself and remains the cornerstone of prudent investing.
 
Diversification simply means having exposure to many 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. There also are some online tools that give you ideas about ways to increase your diversification and simultaneously lower your risk.
 
Eve Kaplan, CFP, is a fee-only advisor in Berkeley Heights, N.J. Kaplan Financial Advisors is a Registered Investment Advisor in New Jersey and New York.
 
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