Fashions And Investment Folly

Fashion is the great governor of this world; it presides not only in matters of dress and amusement, but in law, physics, politics, religion, and all other things of the gravest kind; indeed, the wisest of men would be puzzled to give any better reason why particular forms in all these have been at certain times universally received, and at other times universally rejected, than that they were in or out of fashion.

 Henry Fielding, The True Patriot

In investing, as in fashion, fluctuations in attitudes spread widely without any apparent logic.

Psychologists have long known that individuals allow themselves to be influenced by the herd mentality, or the “madness of crowds,” as Charles MacKay, author of Extraordinary Popular Delusions and the Madness of Crowds, described it back in 1841. The herd mentality is a desire to be like others, to be part of the “action” or “scene.” This mentality manifests itself in the fashion world where, like the length of a skirt or the width of a tie, fashions come into and go out of favor for no apparent reason. But fads are not limited to the world of fashion. Fads come and go in most endeavors. For example, in the 1950s, westerns dominated television screens. Today, there are no westerns to be found. Later, situation comedies became the staple of network television. Today, we have reality shows. Even diets come and go, from the grapefruit to the South Beach to the low-carbohydrate diet.

Since fashions affect social behavior, is it not logical to believe they affect investment behavior as well? Charles MacKay put it this way: “Every age has its peculiar folly: Some scheme, project, or fantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the force of imitation.”1 Sir Isaac Newton was reported to have said about the investment mania of his day, the South Sea Company: “I can calculate the motions of heavenly bodies, but not the madness of people.”2

When it comes to investing, otherwise perfectly rational people can be influenced by a herd mentality. The potential for large financial rewards plays on the human emotions of greed and envy. But whereas changing the length of a skirt or width of a tie won’t affect your net worth in any appreciable manner, allowing your investment decisions to be influenced by the madness of crowds can have a devastating impact on your financial statement.

Perhaps one of the most amazing statistics about the world of investing is that there are many more mutual funds than there are stocks, and there are also more hedge fund managers than there are stocks. And there are also thousands of separate account managers. The question is: Why are there so many managers and so many funds? There are several explanations for this phenomenon. The first is the all-too-human tendency to fall subject to “recency.”

As we age, our long-term memory skills tend to remain strong, while our short-term memory skills erode. Unfortunately, individuals don’t benefit from that tendency when it comes to investing. It is a common human failing to fall prey to recency – the tendency to give too much weight to recent experience while ignoring the lessons of long-term historical evidence. Investors subject to recency make the mistake of extrapolating the most recent past into the future, almost as if it is preordained the recent trend will continue. The result is whenever there is a hot sector, investors rush to jump on the bandwagon and money flows into that sector. Inevitably, the fad (fashion) passes and comes to a bad ending. The bubble inevitably bursts. The result is investors follow a strategy of buying high and selling low – not a recipe for investment success.

But that is a matter of perspective. While investors almost invariably do poorly, mutual funds collect huge fees, advertising revenues for the financial media soar as Wall Street’s marketing machines gear up to exploit the latest frenzy, and subscription revenues soar as investors yearn to learn how they can become rich quick.

The advertising machines of Wall Street’s investment firms are great at developing products to meet demand. The record indicates they are even great at creating demand where none should exist. For example, when the biotechnology craze occurred, investment firms rushed to create biotech mutual funds. When the technology craze hit, technology funds were created by the hundreds. Then telecom became the hot industry, and scores of telecom funds were created. The Internet became the greatest craze of all and funds were created to exploit the demand. How many investors made their fortunes investing in those sectors? Surely more fortunes were lost than were made. The latest fashions include cloud computing and electric vehicles.

The financial craze was once for Japanese funds, emerging market funds, small-cap funds, value funds, and so on. When the craze eventually petered out, while some of the funds disappeared, the vast majority remained alive (at least for some period of time). Hence the number of funds tends to grow over time. However, this trend, at least for mutual funds, has changed and there are now fewer funds than there were at the height of the Internet frenzy. This is a result of many poor performers being either merged out of existence (to make their track record disappear) or simply closed due to a lack of sufficient funds to keep them alive.

It is rare for a new fund to be brought to market when an asset class has performed poorly. A perfect example is the asset class of emerging markets. When the asset class was providing great returns from 1987 through 1993 (about 35% per year), there was a proliferation of emerging markets funds. The asset class performed poorly after that, producing negative returns from 1994 through 2002. By the end of 2003, Morningstar was able to list only 16 emerging market funds with a 10-year track record.

There is a second reason for the proliferation of funds. The Wall Street machines know that the track record of active managers is one of inconsistent and poor performance. Thus, a family of funds may create several funds in the same category in the hope that at least one will be randomly hot at any one time.

One explanation is that investors feel trapped by taxes. (The shares they own have a relatively low-cost basis.) Thus, they won’t sell shares in an under-performing fund – but they won’t invest any new money either. To attract new funds, there has to be a fund with a record of recent hot performance, allowing it to attract the performance-chasing dollars. Thus, there is not only the need for a number of funds (hoping at least one will be randomly hot) but the need to regularly create new ones.

One of the great things about the capitalist society we live in is we have freedom of choice. Unfortunately, that is a bad thing if investors are not educated about how the world of investing works. A lack of education allows investment firms to exploit investors who are constantly seeking the “Holy Grail” of outperforming the market. The end result in most cases is poor investment results despite large profits for investment management and brokerage firms.

The moral of the tale

Investors are best served by developing an investment plan that addresses their ability, willingness, and need to take risk. The next step is building a globally diversified portfolio and adhering to that plan; ignoring the noise of the market and the emotions that are aroused – emotions like greed and envy whenever and wherever bull markets occur, and fear and panic when bear markets happen.

Investors are also best served by using passively managed funds to implement the plan; this is the only way to ensure they do not underperform the market. By minimizing this risk, they give themselves the best chance to achieve their goals. And if investors adopt the winner’s game of passive investing, they will no longer have to spend time searching for that hot fund. They can spend time on far more important issues.

1 Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds (Barnes and Noble 1994).

2 Quoted in Edward Chancellor, Devil Take the Hindmost, p. 69 (Farrar, Straus and Giroux 1999).

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