Ken Eisold Ph.D.

Hidden Motives

Investors Following the Crowd

Wisdom and folly

Posted Dec 01, 2014

The wisdom of crowds doesn’t apply to picking stocks.

A new study published in the Journal of Portfolio Management shows that “hot stocks,” those that generate a lot of buzz and, as a result, move a lot, generally do not do well: “Measured by turnover, the more popular a stock, the less its return; the less popular a stock, the higher its return.”

They attribute the allure of hot stocks to publicity in the media and investor over confidence. If a large number of investors are influenced by those factors, then prices will go up temporarily, but that can also “reduce the potential for appreciation in the longer term.” “Disappointment often follows,” as the report on the study in The Wall Street Journal noted.

It has been well established that the safest and surest way to succeed in the stock market is to invest in a basket of securities that reflect an index, such as the Dow Jones. Unexciting, but well proven.

Most of us just don’t have enough information to succeed otherwise. Stocks often rise and fall on quarterly earnings reports, but as The Journal noted, to profit from those swings is “like picking up pennies in front of a steamroller being driven like a Ferrari.”

Even professionals are led astray, and find it difficult to outperform “Index Funds.” There are exceptions, of course, like Warren Buffet. But even brilliant managers of hedge funds are often tempted by insider knowledge to try staying ahead of the crowd. They end up being prosecuted and paying big fines – if not in jail.

The “wisdom of crowds,” as James Surowiecki put it in his book, only applies when individuals actually do not know what others are thinking, when they are exercising autonomous judgments and those judgments are aggregated. The classic example he uses is people independently estimating the number of marbles in a jar. Most estimates are wrong, but the average of estimates is astonishingly accurate.

It turns out that looking to your neighbor to see how many marbles he sees in the jar is a sure way to get it wrong. In the stock market as well, the pressure to fit into the crowd and conform takes over and will lead you astray.

The Journal summarized the figures: A few hot stocks, like shares Tesla Motors are made huge gains. “But 14 of the stocks on the list [of most active shares] are down this year . . . even though the stock market is rallying and the S&P 500 has closed at a record 47 times. Social-media company Twitter has fallen 38%, Internet radio provider Pandora Media is down 27%, and daily-deals site Groupon is down 36%.”

The bottom line: “An investor who split $10,000 equally among the 20 stocks at the start of the year would have had only $9,152 by Tuesday, including dividends . . . . The same $10,000 invested in the broad-market S&P 500 index would have grown to $11,391.”

Boring but safe.