Investors who play follow the leader often do well
If all your information came from brokerage ads, you'd assume that the very best investors are hard-charging, independent-thinking men and women who scorn conventional wisdom. You'd also assume that they spend a lot of time taking off their glasses, folding their arms and staring off into the middle distance.
Both assumptions are, of course, wrong. Many smart Wall Streeters wear contacts. And though there are some very good contrarians out there, the vast majority of Wall Street investors do what everyone else does. And, surprisingly, that's not always such a bad strategy.
John Maynard Keynes, the famed economist, once noted that the stock market is a bit like a beauty contest. Rather than try to pick the most beautiful person, the judges in a Keynesian beauty contest try to figure out which contestant everyone "else" will pick. A stock may be genuinely attractive, after all, but it rises in value only if everyone else thinks it's attractive, too.
Just what makes all other investors start to love a particular stock or sector is hard to say. But once a stock starts to rise in price, other investors will often jump on board. On Wall Street, as in space, objects in motion tend to stay in motion, and price momentum can last a surprisingly long time.
For example, let's suppose you had resolved to buy the previous year's top-performing fund at the start of each year. So on Jan. 1, 1999, you invested in 1998's top-performing fund, Kinetics Internet, which gained 196 percent in 1998. You hit pay dirt: The fund leaped 216 percent in 1999.
Unfortunately, Kinetics Internet plunged 51 percent in 2000. Had you continued your system of buying the previous year's hottest fund, you would have sold Kinetics Internet at the start of 2001 and bought Van Wagoner Emerging Growth, which tumbled 20.9 percent that year. Yet despite the losses, the system would have turned $10,000 invested at the start of 1999 into $93,000 by the end of 2007.
As you might suspect, this is a very selective example. If you had started by investing $10,000 with Van Wagoner in 2000, for example, your account would have produced $29,500 by now. Others, though, have studied similar "hot hands" strategies and come up with highly impressive results.
The No-Load Fund Investor, a newsletter, has followed its Persistency of Performance system since 1976. The system simply buys the previous year's top-performing diversified U.S. no-load stock fund. But it tosses out some of the new ultra-bull funds, which use futures and options to amplify returns. The newsletter's system has averaged a 21.5 percent average annual gain since inception, compared with 14 percent for the average diversified fund.
Last year's pick, FBR Focus, though, gained just 2.3 percent for 2007, versus 6.3 percent for the average U.S. diversified fund and 5.5 percent for the Standard & Poor's 500-stock index with dividends reinvested.
This year's pick is CGM Focus, run by superstar manager Kenneth Heebner. The fund soared 80 percent last year. Mark Salzinger, editor of The No-Load Fund Investor, says that despite that fund's relatively few holdings - 24 - the portfolio is spread among enough different issues to qualify as diversified.
Following hot sectors has generated good results, too. Sam Stovall, chief investment strategist for Standard & Poor's, tracked a portfolio that invested in the three best stock sectors of the previous year. The portfolio has gained an average 10.8 percent a year since 1990, compared with 9.2 percent for the S&P 500. The best sectors of 2007 were energy, utilities and materials.
Stock sectors cover broad swaths of the market, such as utilities or health care. Another portfolio proposed by Stovall would invest in the previous year's 10 top-performing sub-sectors, which range from autos to shoe manufacturers. The sub-sector portfolio has gained an average 13.7 percent since 1970, vs. 7.6 percent for the S&P 500.
The danger with any momentum system, of course, is the sudden jolt when momentum ends. In a worst-case scenario, you could start investing in a hot fund just before a big plunge. Case in point: The top-performing fund of 1997 was the American Heritage fund, which plunged 61 percent in 1998.
This isn't a strategy to follow with money you can't afford to lose. It's also not a strategy to follow in a taxable account, or in one with high brokerage fees. Your profits - if any - would be swallowed by taxes and expenses. Nevertheless, following the herd on the Street isn't always such a bad idea.
WBJ Web Partners
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