Economic News & Analysis—August 13, 2012
Go with the crowd, or against it?By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist
From the sounds of some commentators, you’d think that the best investment strategy a retail investor could possibly take would be to look at what other investors are doing and then do the exact opposite.
There may be a nugget of truth to the idea that success lies in going against the crowd, but it’s probably not an approach to practice mechanically. It’s tough to distinguish when the crowd is wise and when it’s foolish.
For example, I looked at monthly return and mutual fund-flow data from the Investment Company Institute (ICI) for U.S. stock funds and taxable bond funds since 1993. During that time, stocks outperformed bonds 68.2% of the time over a 12-month horizon. In a month during which bond funds raked in more money than stock funds, stocks did better than bonds 73.9% of the time. This suggests that it pays to go against the flow: When others are piling into bonds, maybe it’s time to get into stocks.
The crowd may typically be wrong
Many reasons why the crowd is typically wrong in its investment decisions have been studied in the field of behavioral finance. For example, investors can show a cognitive bias toward recent trends and ignoring longer-term trends. As a result, investors may take the most recent market indicators and extrapolate them into the future. This is actually very consistent with what I found in the data, as mutual fund flows tended to be more highly correlated to the trailing 12-month returns of an asset class than the next 12 months’ returns. Fund flows typically do a better job of predicting the past than the future.
Investors also tend to be late to the party. Fund-flow data tends to be relatively insensitive to returns over the time period of three months or shorter. It appears that investors need to wait for confirmation that an asset class has done well before investing in it. The problem, of course, is that by then, it’s too late to reap the benefits.
But it can pay to go with it
Although the preceding line of argument would suggest that it always pays to go against the crowd, it can pay to go with it. Short-term fund-flow information can point to positive performance of the asset class if there is a positive feedback loop, with money flows driving up security prices, enticing new money flows, and driving prices higher.
To quantify whether it’s better to go with or against the crowd, I looked at the relationship between asset class fund flows and the future 12-month returns versus the trailing 12-month returns. I measured the difference between the next 12-month returns and the trailing 12-month returns for U.S. stocks using the S&P 500 Index as the asset class’s proxy, and for taxable bonds, using the Barclays U.S. Aggregate Index as the proxy.
Table 1. Stocks: Future 12-month returns minus trailing 12-month returns
Table 2. Taxable bonds: Future 12-month returns minus trailing 12-month returns
Table 3. Stocks versus taxable bonds: Future 12-month returns of stocks minus future 12-month returns of bonds
Looking at each asset class in isolation, it appears that the median percentile (50th), the 75th percentile, and the maximum percentile are better when fund flows are negative. This would lead us to conclude that it’s typically better to go against the flow—if you think the future is going to be better than the past. However, the returns when flows are positive are better for stocks at the 25th and the minimum percentiles and better for bonds at the minimum percentile. This would lead us to conclude that if you think the future is going to be worse than the past, it might pay to go with the crowd. Comparing fund flows across asset classes is more problematic. When bond fund flows are greater than stock fund flows, the crowd typically seems to get things right, except in the extreme case when stocks really outshine bonds.
There is no easy answer to the question of whether to invest with the crowd or against it. Based on history, fund-flow information is just one of several factors to look at when making an investment decision. Rather than asking what’s popular, wisdom would suggest that making your own decision—based, perhaps, on the fundamentals—may lead to success more often than modeling your investments on what the crowd is—or is not—doing.
Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Some funds, including nondiversified funds and funds investing in foreign investments, high-yield bonds, small- and mid- cap stocks, and/or more volatile segments of the economy, entail additional risk and may not be appropriate for all investors. Consult a fund's prospectus for additional information on these and other risks.