The most succinct rule of good investing is wonderfully simple: “buy low, sell high.” We all know this, and most of us think it is so obvious as not to be worth saying at all. And yet… and yet it is a rule that investors keep on breaking. In January, with sliding markets grabbing the headlines, investors sold out of equities – to the tune of around $60 billion1. Why is it we repeatedly give into our emotional impulses along the investment journey, despite repeatedly denying (in saner moments) that we’d do so? Why do we buy high, sell low?
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The answer lies in the perennial truth that, in investing, there is usually a chasm between the financially efficient decision and the emotionally comfortable decision. And in the face of a threat, humans crave comfort more than they aspire to efficiency. There are few things more uncomfortable than going against the herd, particularly when it seems to be costing you money. The herd provides comfort, and can turn a fear-driven action into the only accessible one. And if it turns out to be wrong in the end, then at least you have the comfort of knowing that you were in good company.
Much has been made of the wisdom of crowds: the notion that the crowd often knows something that investors individually do not. But, crucially, crowds are only wise when the individual participants arrive at their opinions independently. When investors instead borrow their opinion from the crowd, the result is a feedback loop that drives the aggregate opinion ever further from reality. Ironically, as soon as a crowd is regarded as a source of wisdom, it ceases to be so. The market doesn’t know anything; it is merely a reflection of the average emotional state of its participants. And since we know that individual investors typically have emotional states that are heavily influenced by myopic, often irrelevant, aspects of the immediate context – and are divorced from dispassionate assessments of long-term risk and return – we certainly shouldn’t consider this average emotional state to be any guide to investment decisions. When the crowd stops weighing market fundamentals and turns to itself as a signal, it becomes an emotional amplifier rather than a knowledge aggregator.
Of course in the short-term, this madness of the crowd can be self-fulfilling and drag the market along with it – but in the long-run this merely creates a dislocation between popular perception and reality, which must, at some point, snap back into place. It feels cool to be with the in-crowd, but betting against reality must eventually be expensive.
One other aspect of the crowd is important: because crowds amplify emotion at the expense of reason, they are frequently very indiscriminate in their opinions, and impervious to facts and evidence. So not only do they push prices out of alignment with fundamental value, but they often don’t differentiate between good and bad assets when doing so. Two commonly-used phrases in the financial media these days are ‘risk on’ and ‘risk off ’ – markets can fluctuate between days when everyone either seeks to buy risky assets (risk on), or tries to dump them (risk off). On these days, the herd is making blanket judgements about entire categories of assets, and investors fail to discriminate between good and bad stocks - they blindly sell everything. This effect can result from any label that becomes associated with emotional hopes or fears, but if investors can remain apart from the popular delusion there are considerable opportunities in thoughtfully evaluating assets fallen victim to it.
“The madness of crowds implies an unpopularity premium: unpopular assets are likely to be better value than those widely loved”
For example, if “Europe” is the fear du jour, investors will rush to sell anything even vaguely European, regardless of underlying quality. For thoughtful investors, it might be beneficial not just to buy in the face of such panic, but also especially to seek European stocks that are unjustifiably unpopular, and therefore good value. For example, those which earn much of their revenue outside Europe: they will be.
The madness of crowds implies an unpopularity premium: unpopular assets are likely to be better value than those widely loved. This is particularly true of any that are out of favour because they’re being judged by superficial emotional labels that are not truly reflective of the underlying reality.
Classical finance theory tells us that ultimately the only thing the market should reward investors for is risk: risky assets should earn better returns than safe assets because, in aggregate, investors avoid risk unless they are paid for it. However, the reality seems much more complex: small stocks earn more than they should compared to large stocks; value stocks more than they should compared to growth stocks; and low volatility stocks earn more than they should compared to high volatility stocks. All of these anomalies can be explained by popularity: in general small companies are less well known and less popular than large ones; value stocks appear more pedestrian and less exciting than growth stocks; and low volatility stocks are shunned as less likely to beat the benchmark than their volatile cousins2.
Investors are rewarded for embracing the unpopular. So if you prefer superior returns to social validation, seek out the dull, the discarded, and the unjustly overlooked of the investment world, and run against the herd.
1 Investors pull more than $60bn from mutual funds in January, Financial Times, 28 February 2016
2 Ibbotson & Kim, “Risk Premiums or Popularity Premiums?”