A Fascinating Insight – The Folly Of Herd Mentality

31st Dec '12 by Christopher OLeary

3 comments 15571 reads

One particular article from Hargreaves Lansdown’s (HL) May 2012 edition of their monthly investment literature caught my attention. It is titled ‘The Psychology Of Investing’ by Ben Yearsley, a HL Investment Manager; his findings are eye-opening.

He identifies one of the most well known and successful investment funds during the 1980’s and 1990’s, which was the ‘Fidelity’s Magellan fund’. The fund delivered an eye-watering average annual return of 20%! Its stellar performance was principally attributed to the star fund manager ‘Peter Lynch’. However, the intriguing part of this article is when Ben Yearsley highlights Peter Lynch’s belief that the average investor in his fund only generated an annual return of 1-2%.

The reason for this disparity - the fund didn’t deliver its returns smoothly. Therefore investors typically bought in after 2 or 4 years of phenomenal performance and consequently sold when they became disillusioned with poor performance. Had investors stayed invested for the whole period, they would have shared in the funds spectacular returns. I hazard a guess that this divergence is true of many top performing funds today.

Hargreaves Lansdown’s motto to investors is ‘Time in the market, not timing the market’. I couldn’t agree more.

Interestingly, he then displayed a graph highlighting fund inflows (purchases minus redemptions) since 1992 set against the FTSE 100. The results – Investors purchases of collective investment products nearly always reached peak at the tops of the market, in this case 1999 and 2007.

This graph below illustrates the problem of market timing. The chart shows equity fund net inflows, which are virtually a mirror of image of the FTSE 100 and the S&P index.

In my view, this revelation certainly buttresses the case for contrarian investing and illustrates the psychological folly of following the herd. For example who would have believed that March 2009, the nadir of the market, would have been the right time to invest? It would have taken tremendous courage, but of course that’s the precise time you should have been investing.

Successful Investors would do well buying when they were scared witless. For example, Spanish and Italian equity markets presently trade at over a 60% discount to their CAPE (cyclically adjusted price to earnings ratio), according to Haver analytics. Despite the possibility of a euro zone breakup, does any investor reading this…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Daytona

27th Jan '13

Timing is the most important indicator of future returns. Buy something that is historically overvalued and poor future returns are almost guaranteed. Buy something that is historically undervalued and good future returns are almost guaranteed. Chapter 1 of the 2009 edition of the long running Barclays Capital Equity Gilt Study comprehensively debunks the myth that timing is insignificant -

"The rather brutal lesson we can glean from the past 10 years is that valuations, rather than macroeconomic conditions, and the progress of corporate profits, are the core determinant of equity market returns.
.
.
Over the long run, equity valuations appear to be the primary driver of equity returns, with economic conditions and profit trends contributing little, if anything, to the overall total return from an investment in equities."

Cuthbert C

29th Jan '13

With OEIC's, or whatever unit trusts are called these days, it is, I think, the case that redemptions have to be funded by the fund selling. So if investors quit when the market is weak, that forces the fund to sell when the market is weak. Conversely investors arriving when the market is strong, force the fund to buy when the market is strong. That maladroit selling and buying must itself affect the market even if only temporarily. It seems reasonable to expect that the effect of that situation will be to push in the same direction as the market has been travelling. In other words to push the market in the direction of overshooting at both the top and the bottom of market extremes. That should surely be something that canny investors can profit from. Can we take the inflow of new funds as an indicator of the proximity of a market downturn? And the outflow as indicating the reverse? How do we source such data? Is it readily available?

Moving on from the issue of unit trusts, it seems to me that the funds managed by investment trusts are sheltered from the influence of investors poor timing. They do not have to concern themselves with the investment of new funds at the top of the market or redemptions at the bottom. They have a fixed pot to play with and can manage holdings on their own merits rather than to reflect punter's movements. Of course the actual share price of IT's will be subject to the overshooting effect but that's a different matter from the funds under management and the shareholdings which they are embodied. Presumably the volume of trades provides a useful indicator in this context and that is readily available. One might also expect that the discount/premium to NAV would be helpful in this respect. So a chart showing the share price, the volume of sales and the discount might help to identify inflexion points. Sounds like a trivial proposition - a trusim - but might be worth playing with even so.

loglorry

As T points out here quite a bit of tail wagging dog going on here. It is almost a tautology to suggest that as net cash goes in and out of equities the prices go up and down. I'm not sure how you know when the bottom is reached with respect to outflows or top is reached with respect to inflows though so how do you turn this into a buy/sell signal?

One other correlated function is profits of retail broker firms like TD Ameritrade etc. retail brokers make most money during bull markets when there is a lot of trading as retail punters pile in and so their profits probably peak at the tops of markets. Same sort of thing really.

A Fascinating Insight – The Folly Of Herd Mentality

Unlock the rest of this article with a 14 day trial

About the Author

Christopher OLeary

3 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...