Secrets Of Success: Follow the crowd and pay the price

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The Independent Online

The evidence that supports it is powerful, and not that hard to find. At the annual Legg Mason investment conference in London a few days ago, some of the evidence was rehearsed by Michael Mauboussin, the firm's chief investment strategist. His arguments also feature in a book he has written about the biases and quirks of investors, to be published later this year.

Mauboussin showed a slide analysing the subsequent performance of funds that had achieved the highest and lowest inflows in the United States over 1979-2002. This was supplemented by ranking the sectors on whether they were highly or lowly valued against their historical average. (Funds that are popular tend to carry relatively high valuations because they mostly have enjoyed strong recent performance.)

The findings were both interesting and uniform. On average, funds that were relatively highly valued and obtained high inflows underperformed the market by 4.9 per cent over the subsequent two years, while those that had high outflows and low valuations outperformed the market by 8.7 per cent. The most popular funds, in other words, did relatively poorly while those that were cheap and unpopular did materially better. The same pattern has been confirmed in UK studies, underlining that this is a generic problem in funds, not country-specific.

Another interesting piece of evidence Mauboussin referred to reinforced the point that ordinary investors are drawn like moths to a flame to those funds or sectors that have had the best recent performance. As a result, they not only tend to end up buying things that will underperform in due course, but also in practice make big bets against the market, which theory and experience tell us is a riskier strategy.

For example, at the end of March, surveys of US retail investor portfolios suggested that they had almost half their holdings (45 per cent) in just two sectors, energy and precious metals, which are also (not by chance) the sectors that had the highest five-year returns at that point. The comparable market index weighting, as measured by the S&P 500 index, is about 11 per cent. By contrast, investors had only 5 per cent in financials and technology, which have had much inferior track records over the past five years, but still account for 37 per cent of the market index.

It would be nice to think that the reason for such high weightings in energy and precious metals is that investors correctly spotted their future performance five years ago. It would be nice also to think that they would time their exit from these two sectors at just the right moment as well.

But unfortunately, the evidence is simply that retail investors are not that good at timing their moves in and out of the hottest-performing sectors. All the evidence I have seen, including the data on fund flows, suggests that the opposite is more usually the case.

Jack Bogle, founder of Vanguard, recently updated his analysis of US fund investors' performance to cover the 20 years to 2003. During that period, while an S&P index fund returned an average of 12.8 per annum, the average fund (because of costs) only made a return of 10 per cent a year, and the average fund investor (because of poor timing) managed only 6.3 per cent a year.

These are scary figures. They suggest that the average fund investor only makes about half of the return that would be available to anyone simply following an index-tracking strategy. If you assume that returns across the fund investor spectrum are normally distributed, then it follows that a relatively small minority of smart, disciplined investors are making a lot of money at the expense of - and, in effect, from - those who act with the majority.

The majority either don't appreciate that this is happening, or cannot break the costly habits that produce these lopsided results.

In most cases, apart from the natural human tendency to want to follow what others are doing, the fundamental problem is that those without professional skills are unable to distinguish between the price and the value of an investment. (In Warren Buffett's phrase: "Price is what you pay, value is what you get.") So, while it is easy to discover that supply and demand for many commodities are out of whack - obviously a trigger for higher prices - the real question is whether that imbalance is already incorporated in today's price.

For those who understand these dynamics, part of the answer lies in imposing a discipline that forces you to stay on the value side of the line when all your instincts may tell you to follow the crowd in another direction. This may be achieved by following a rule-based system that takes a lot of decision-making out of your hands. A good example would be a simple stock-picking system like the Dogs of the Dow theory, based on picking a handful of large-cap stocks with the highest dividend yields at the start of the year and doing nothing for the rest of it. That simple technique has beaten the market for three years running and is ahead again this year. An index fund is another example of a rule-based system that scores well over longer periods because human intervention is virtually eliminated.

jd@intelligent-investor.co.uk

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