Follow the leader

1. Introduction
2. Popular 401K investors delusions
3. Fashionable mutual funds mix
4. Follow the leader
5. Naive siegelism
6. "Financial alchemist" strategy
7. Stable value only or "Depression might start tomorrow" strategy.
8. Bonds-based strategy
9. "Gold always shines bright"  and "Commodities rulez" strategies
10. Lifecycle strategies
11. Economic cycle based market timing
12. Combination of lifetime strategies with market timing.
13. Conclusions
14. Webliography
15. Old News

Following hot, rising funds is a very popular strategy. It is often called momentum investing strategy. Wikipedia defined it in the following way:

Momentum investing is a system of buying stocks or other securities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period. It has been reported that this strategy yields average returns of 1% per month for the following 3-12 months as shown by Narasimhan Jegadeesh and Sheridan Titman.

While no consensus exists about the validity of this claim, economists have trouble reconciling this phenomenon using efficient market theory. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk for assuming this strategy, and thus the high returns are compensation for the risk. The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over and underreaction, and confirmation bias. Seasonal effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.

Some investors may react to the inefficient pricing of a stock caused by momentum investing by using the tool of arbitrage.

It is believed that George Soros (1987) used a variation of momentum investing by bidding the price up of already overvalued equities in the market for conglomorates in the 1960's and Real Estate Investment Trusts in the 1970's. This strategy is termed positive feedback investing.

Richard Driehaus, the founder of Driehaus Capital Management, Inc., is widely considered the father of momentum investing. This Chicago money manager takes exception with the old stock market adage of buying low and selling high. According to him, "far more money is made buying high and selling at even higher prices."

And with some caution and objective "stop signals" it can produce good results. As note USA Today columnist John Waggoner (I highly recommend his columns) noted in his Jan 3, 2008 column Investors who play follow the leader often do well: 

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 (WWWFX), which gained 196% in 1998. You hit pay dirt: The fund leaped 216% in 1999.

Unfortunately, Kinetics Internet plunged 51% 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 (VWEGX), which tumbled 20.9% 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% average annual gain since inception, compared with 14% for the average diversified fund.

Last year's pick, FBR Focus (FBRVX), though, gained just 2.3% for 2007, vs. 6.3% for the average U.S. diversified fund and 5.5% for the Standard & Poor's 500-stock index with dividends reinvested.

This year's pick is CGM Focus (CGMFX), run by superstar manager Kenneth Heebner. The fund soared 80% 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% a year since 1990, compared with 9.2% 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% since 1970, vs. 7.6% 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 (AHERX) fund, which plunged 61% 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.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. Click herefor an index of Investing columns. His e-mail is [email protected].

Money) -- Question: In December, 2005 I spread the $200,000 in my 401(k) account across funds that had gained 20 percent or more a year over the previous three years. Those funds gained about 30 percent in 2006. I'm following the same strategy this year and so far I'm up about 30 percent. I should add, though, that following this strategy has put about 65 percent of my money in foreign stock funds, and I've also ended up with several sector funds. I've got another 10 to 15 years before I retire. Am I being brilliant or blissfully ignorant of risk? - Forrest, Madison, Alabama

Answer: You could be both for all I know, and just plain old lucky too for that matter. The real question is whether it makes sense for you to continue following your "invest in the stars of yesteryears" strategy or whether you should take a more conventional approach and build a truly diversified portfolio.

At the risk of sounding like a narrow-minded fuddy-duddy unwilling to think outside the box, I have to say that, despite the tantalizing returns you say you've earned so far, I can't recommend that you stick to this strategy or that anyone else adopt it.

I know that I wouldn't (and don't) invest my own retirement money this way. And I can't in good conscience suggest that you do. Here's why. Mechanistic investing systems have been around a long time. The variation you're using is basically a form of momentum investing, the basic principal of which is that an investment that's done well recently will continue to do well at least for some time in the future.

The idea is similar to Newton's first law of motion, which says that a body in motion tends to stay in motion unless acted upon by an outside force (in the case of investing, that outside force would be a shift in the markets). There are a variety of ways to employ a momentum strategy - you're going with three-year performance, but others have gone with one-year performance or other time periods.

Other people take the opposite tack - that is, buying investments others shun (or funds whose investment strategies are out of favor) on the theory that these investments and funds will bounce back.

Basically, this is a form of value investing and the Dogs of the Dow strategy - buying the lowest yielding Dow stocks each year - is one of the better known ways of pulling it off. And there are countless other systems out there floating around.

Indeed, I get inundated on a regular basis with emails and snail-mail from investors, marketing organizations and others touting all sorts of algorithms, processes, systems and schemes that purport to beat the market, identify the best stocks or mutual funds, guarantee high returns at low risk or do all of these things combined.

Do they work? That's hard to say. I'm sure that most systems can point to some periods where they've had success. In fact, most of these systems are created by trying a variety of strategies and "backtesting" them - that is, see how they performed in the past.

But the fact is, determining whether a system that's done well in the past is likely to go on doing so because it tapped into some fundamental market "truth" or whether it worked well because market forces just happened to be aligned in a particular way that may not be repeated in the future would require tons of time and effort.

Indeed, you could spend your life trying to validate (or invalidate, as the case may be) the seemingly endless stream of foolproof investing systems. So while I can't tell you that your system or anyone else's is flat-out wrong or doomed to fail, I can say that just because a stock or fund turns up at the top of a list or screen doesn't mean its presence there is meaningful.

Would it matter to you if the fund you were about to buy because it passed your three-year performance screen was being run by a new manager who arrived within the last year or so and thus had nothing to do with the fund bubbling to the top of the performance charts? Or how about if the fund had changed its investing focus over those three years? Or had zoomed from $100 million in assets to $1 billion? Do you think such factors might affect future performance?

Suffice it to say that, just as I'm wary of fad diets and dietary supplements that promise huge weight loss, I'm also leery of any mechanical system that suggests you can get results well beyond the raw returns the financial markets offer. We'd all like to find some secret formula that leads to blowout returns. But in my experience the world doesn't work that way. And in my opinion, people who believe there are such magic-bullet solutions are deluding themselves.

That's not to say that you may not continue to rack up decent or even impressive gains for a while. On the other hand, it's also possible that a major turn in the market will wreak havoc with your portfolio, much the way the bottom fell out of tech and other aggressive growth stocks after the 1990's boom. This may be a particular danger for you in that your system has led you to a concentration in foreign stock and sector funds.

Foreign stock fund returns have been particularly strong lately in part because of the weak U.S. dollar. A rebound in the greenback combined with a natural downturn in foreign markets after a nice run-up could inflict a big hit on a 401(k) that's invested so heavily in foreign shares.

As for loading up on sector funds, well, they're inherently volatile because they home in on just one area of the market. If you want to see how much their returns can jump around, just go to the Category Returns section of the Funds section of Morningstar and check out the performance of some of the funds in specialty areas like technology and precious metals.

All of which is to say that I think you're much more likely to accumulate the nest egg you'll need for retirement by taking a more traditional approach. Start by creating a mix of stocks and bonds that makes sense for someone your age and with your tolerance for risk. For more guidance on how to do that, click here and here. Then, choose funds that have low annual costs and that have a solid record of delivering consistent gains. Note that I said "consistent," not funds that have the highest gains in any given year.

You can find such reliable performers in the Money 70, our list of recommended funds. If your 401(k) doesn't offer any of these choices, you can at least choose from among your 401(k)'s lineup using the same fund-picking philosophy we used to come up with the Money 70.

And if you want to tilt the odds even more in your favor, you should consider putting the bulk of your retirement money in index funds, assuming your 401(k) plan offers them, as most plans do nowadays. The combination of index funds' low operating costs and their consistent investing style makes it likely they'll outperform most other funds over the long term.

I'm not going to claim that my approach will generate the highest returns. Indeed, by spreading your money among a variety of asset classes you virtually assure that your portfolio overall won't do as well as whatever funds are topping the performance charts in any given year. But if you follow my advice, you will be investing in a way that allows you to earn competitive returns while also protecting yourself somewhat against market setbacks.

I don't think you can say the same with what you're doing, particularly as regards risk since you end up with such a concentrated portfolio. Ultimately, it's your decision whether to continue investing on the basis of your system. But if I were you I'd thank fate, the investing gods or whatever and get out now while I'm ahead - or at the very least greatly reduce the amount of money I invested using this strategy. I'm all for experimentation. But not at the expense of my retirement.

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Last modified: March 12, 2019