Apr 7th 2011 | from the print edition
IF YOU see a crowd outside a department store it is reasonable to assume that there is a sale. If you see a queue outside a bank there is a good chance that nervous depositors are trying to withdraw funds. In both cases the actions of other people send a signal that may be useful for others to follow.
But does the wisdom of crowds apply to investment? At the peaks it certainly pays to head in the opposite direction from the masses. Bubbles occur when the population develops an enthusiasm for a particular asset class, whether it be technology stocks in the late 1990s or houses in the mid-2000s. The story goes that in 1929 Joseph Kennedy liquidated his portfolio when he heard that a shoeshine boy (in some versions, an elevator boy) was giving stock tips.
Bubbles are relatively rare, however. In the normal course of events, following the crowd may be more profitable. After all, bond-market vigilantes are supposed to keep a wary eye out for inflation, while the stockmarket ought to give an early indication of coming recessions.
To investigate the investment success of crowds, The Economist asked Morningstar, an investment-research firm, to send us fund-flow data and performance statistics for its American mutual-fund range. We then applied some simple tests. Did investors plonk their money into an asset class that had been performing strongly over the previous 12 months? And was their judgment borne out over the subsequent 12 months?
The chart shows that the crowd was more foolish than wise. The most popular sector, measured by the net inflow of money, had generally performed well in the previous year, beating the average sector by more than two percentage points. Investors were clearly chasing the trend. Alas, over the next 12 months that most popular sector lagged behind the average by just under three percentage points. On around 60% of occasions, the return of the most popular sector was much lower after investors bought it than before.
The mob's behaviour might still be useful if it acted as a contrarian indicator. Here there is good news and bad news. So-called "pariah funds" did beat the most popular sectors, but they also failed to beat the average.
There is another test of how psychic investors have been, which is to see how good they were at picking the best-performing sectors and avoiding the worst ones over any given 12-month period. Because the star performers tend to be fairly specialised, covering areas like China, property or Latin America, they are never likely to receive the biggest fund flows. Most American investors opt for broad equity or government-bond portfolios. Again, investors were more Nostradumbus than Nostradamus. The average fund flow into what turned out to be the worst-performing sector over the subsequent 12-month period was $166m; the average flow into the best was only $72m.
Perhaps investors get led astray by the advice they receive. The earnings forecasts compiled by investment-bank analysts and stockbrokers are often used as a basis for valuing shares and for predicting long-term earnings. But in the past quarter of a century the consensus forecast for the long-term annual earnings growth of American companies has never dipped significantly below 10%.
Such a rate was not achieved, of course. It was far faster than the annual growth rate of the American economy, which made the forecasts implausible to begin with. The long-term growth rate of earnings per share on the stockmarket has lagged behind that of American GDP because many of the fastest-growing companies are not quoted. Worse, earnings forecasts peaked in 2000 just as the stockmarket was about to fall. The experts were no wiser than those they advised.
The wisdom of crowds only really applies when forecasts are genuinely independent, as when farmers are guessing the weight of a bull at a country fair. Once you know what others are thinking, their views lead you into error.
Perhaps people are congenitally programmed to follow the herd. Warren Buffett retells the story of the dead oil prospector who gets stopped at the pearly gates and is told by St Peter that Heaven's allocation of miners is full up. The speculator leans through the gates and yells "Hey, boys! Oil discovered in Hell." A stampede of men with picks and shovels duly streams out of Heaven and an impressed St Peter waves the speculator through. "No thanks," says the sage. "I'm going to check out that Hell rumour. Maybe there is some truth in it after all."
Economist.com/blogs/buttonwood
from the print edition | Finance and Economics
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