Why It Isn’t Always Wise To Follow The Wisdom Of Crowds
2022.04.11 13:55
The isn’t always wise to follow. A recent article by Scott Nations via MarketWatch made an excellent point.
What is herding?
According to a CFA Institute survey of investment practitioners globally, 34% stated that the or was the most significant contributor to investment decision-making.
Psychological Factors On Investment Decisions
The top rank for herding is a reminder of the lemming suicide myth in which lemmings end their lives by following one another off a cliff. However, before they can see the cliff’s edge, they believe the in front of them knows where it’s going.
Right In The Middle, Wrong On Both Ends
Over the last few years, we have seen many examples of crowd wisdom. The rise of the terms such as “FOMO.” to “YOLO” and even “TINA” are clear examples of herding.
As others are making money, investors who are participating follow the crowd because they feel their economic status will fall relative to those participating. That behavior causes even more of the same behavior, and bubbles eventually form.
Important Note:
In the very short term, political, fundamental, and economic data has very little influence over the market. Such is especially the case in a late-stage bull market advance where exceeds the grasp of the risk undertaken by investors.
In other words, “ in the short term.
Price measures the current of the and is the clearest representation of the behavioral dynamics of the living organism we call
But in the long-term, fundamentals are the only thing that matters. As the chart below shows, 10-year forward total real returns from current margin-adjusted valuations are not promising.
Valuations Forward 10-Year Returns
We Now Return To Our Message
The effect worked very well for a while as investors chased surging prices supported by government and Federal Reserve interventions.
Investors armed with a fresh stimulus check, a app, and membership to #WallStreetBets piled into many investment options to “
Not surprisingly, it all ended rather poorly.
Historically, following the herd always works in the middle of a market rise or fall. However, is ALWAYS wrong at the extremes.
Investor Psychology Cycle
Source: FX Street Chart Reconstructed By: Real Investment Advice
– Benjamin Graham.
But can we do better as investors?
Rothchild’s Elegant Solution
While it is easy to get swept up by the herd as prices are rising or falling, we can manage the risk in our portfolio.
You can not effectively and repetitively get and of the market in a timely fashion. Such is neither portfolio nor risk management. However, by adjusting market exposure when outweighs the potential for further
Every investment strategy has a consequence and will lose money from time to time. The only difference is the amount of the loss, what causes it, and the amount of time lost in reaching your investing goals.
Baron Nathan Rothschild had an elegant solution to solve the problem. If the is correct in the middle but wrong at the extremes, avoid the extremes.
The following is a graphical example of the 80/20 investment philosophy.
Rothschild-80-20 Philosophy
Putting It To The Test
The 80/20 rule is the basis of our investment management process. Importantly, you will NOT beat the market from one year to the next. However, you will avoid the required to “Such gets shown in the example below.
Rothschild 80-20 Table
Here is a chart to illustrate the deviation more effectively.
Index Returns vs Active Management Example
Notably, even though the model underperforms MOST years, the reduced levels of volatility allowed investors to emotionally to their discipline over time. Furthermore, assets can over the long term by minimizing the drawdowns.
An easy way to apply this principle is to use a simple moving average crossover. In the chart below, an investor is long the S&P 500 index when it is above the 12-month moving average. They would then switch to bonds when the index falls below the 12-month average.
Portfolio Growth (Inflation Adjusted)
Rothschild-12-Mth-MA Model Portfolio Visualizer Table
No, it’s not perfect every time. But no measure of risk management is.
But having a discipline to manage risk is better than not having one at all.
