A history of herding
Whether you’d like to believe it or not, the majority of unadvised investors make avoidable mistakes that significantly impact their portfolios. A good financial advisor, however, will help you modify irrational, emotional behaviours that move most investors to make unsound decisions. A good advisor is also like a therapist, someone who can calm you and prevent you from getting in your own way. The value of advice is not always easily understood but it's critical to helping investors achieve their financial goals. Let's turn to a short history lesson to illustrate how humans have the potential to do significant damage to their own financial wellbeing. Not everyone who had an advisor was able to navigate these situations, but we like your chances a lot better if you have a pro in your corner.
Nothing pretty about this beauty contest
If you haven't heard about the “Keynesian beauty contest”, here's the concept in a nutshell. The legendary British economist John Maynard Keynes observed that investment strategies reminded him of a game once staged by a London newspaper. Readers had to pick out the six prettiest faces from 100 photographs, with the prize being awarded to the reader whose choice most closely corresponded to the average preferences of the competitors as a whole.
Instead of choosing their six favourites, many readers tried to guess whom they believed other readers would select. Clearly, this beauty contest descended into an exercise where efforts were devoted to anticipating what the average opinion expects the average opinion to be. Yeah, we think it sounds ridiculous, too.
What do financial bubbles and beauty contests have in common?
Keynes noticed similarities between reader behaviour and how investors behave in the markets. The decision to buy and sell stocks often involves anticipating how the average investor might value a particular stock. If the price of XYZ stock keeps rising, it must be because other investors think the business will continue to grow, so the crowd piles in without questioning whether the growth is already priced into the current share price. Can you say “FOMO”? (That's "fear of missing out" in case you're not a social media guru.) If everyone ends up being wrong, well, it's much easier to fail conventionally than succeed unconventionally.
Human beings are herd animals. We survive in coordinated groups and align our behaviour with those around us. Many investors seek the perceived safety of the crowd, jumping on the bandwagon when a certain stock or sector is in favour and jumping off when sentiment turns negative. That's how market bubbles grow and burst. Collective greed drives prices higher just as collective fear does the opposite.
So, whether you're judging the attractiveness of contestants or the attractiveness of certain stocks, it's easy to fall prey to blindly following the crowd.
Bubble bubble, toil and trouble
Let's look at some prominent historical examples where irrational investor behaviour moved markets dramatically, creating and erasing huge amounts of wealth in the process.
You may think these examples are from a bygone era. Humans must have gotten better and learned from the past. Guess again! This herd mentality is not relegated to the distant past. Let's go through some more examples from the last 30 years or so.
And let's not forget the recent drama of cryptocurrencies like Bitcoin or marijuana stocks that have taken speculators on a wild ride of dizzying highs and painful lows.
However, despite all the bubbles and busts, the equity market has been the best way to compound wealth overtime. A single $100 investment in the S&P 500 Composite Index in the roaring 20s (1920) would be worth over $1.6 million today on a total return basisx. Time is the chief ingredient behind the magic of compounding. Unfortunately, the sad reality is that most investors would not have captured this return because of their own behaviours.
The value of sound advice
So, what can you do to navigate these treacherous waters? At EdgePoint we strongly support professional financial advice. A decade ago we decided to partner with financial advisors because we believe investors' interests are best served by advisors who have the specialized knowledge and experience to guide you through all market conditions. Digging into the archives, in 2014 we wrote a commentary identifying the key advisor attributes that, in our observation, have generally led advisors to be more successful at helping their clients meet their financial goals.
We went through so many market declines that you may be thinking why would I pay someone if my portfolio is dropping in value? Isn't that making a bad situation even worse? A skilled advisor can help you resist the urge to react emotionally. Your advisor will keep you focused on the long term so you can weather short-term challenges and grow your wealth over time. This doesn't mean a good advisor can prevent your portfolio from declining in value over the short term. However, the patience you exercise during these bubbles and subsequent crashes is what distinguishes a successful investor from an unsuccessful one.
Similarly, maybe you're wondering why you should pay an advisor when your portfolio is making gains. Isn't it better to do it yourself? Good advice also matters in strong markets so you can maintain investment discipline and avoid becoming greedy and venturing into stocks or sectors that everyone is raving about at dinner parties. As you've seen, market bubbles are very real and the consequences when they burst can be devastating.
Keynes would be proud
Find a good advisor and communicate often and openly. Have a solid long-term investment plan. Stick with that plan through short-term market noise. A smart, sensible approach like that is attractive enough to win any beauty contest!
ii "South Sea Bubble" library.hbs.com,. https://www.library.hbs.edu/hc/ssb/history.html/. Accessed on January 15, 2019.
iii Peter Rappoport and Eugene N. White. "Was There a Bubble in the 1929 Stock Market?" The Journal of Economic History,. Vol. 53, No. 3 (Sep., 1993), pp. 549-574.
iv Source: Bloomberg LP. Dow Jones Industrial Average declined 22.6%, or 507.99 points on Oct. 19, 1987
v Source: Bloomberg LP. The Nikkei index (Nikkei 225) declined 63.23% in $JPY, from Dec. 29, 1989 to Aug. 18, 1992
vi Source: Bloomberg LP. S&P/Case-Shiller U.S. National Home Price Index, a measure of U.S. residential real estate prices, declined 27%, from Jul. 2006 to Dec. 2011
vii Source: Bloomberg LP. WTI Crude Oil, a benchmark in oil pricing declined 74.32% from Jun. 14, 2014 to Feb. 10, 2016.
viii Source: Bloomberg LP. Brazilian market as measured by the iShares MSCI Brazil ETF. The iShares MSCI Brazil ETF seeks to track the investment results of an index composed of Brazilian equities. The ETF seeks investment results that correspond generally to the price and yield performance of the MSCI Brazil Index. The iShares MSCI Brazil ETF declined 65.32% in $US from May 26, 2008 to Nov 17, 2008. The Chinese market as measured by the SSE (Shanghai) Composite Index is a stock market index of all stocks that are traded at the Shanghai Stock Exchange. The SSE (Shanghai) Composite Index declined 66.99% from Jan 6, 2008 to Nov 2, 2008.
ix "Shiller S&P composite monthly pricing data", R. Shiller, accessed January 1, 2019, http://www.econ.yale.edu/~shiller/data/chapt26.xlsx. From January 1, 1920 to December 31, 2018 a single $100 investment in the S&P 500 index including dividends would grow to $1,603,225.