Avoid the herd mentality; do your research

By DAVID MOON, Moon Capital Management, LLC
January 13, 2013

January marks the beginning of one of the most active seasons of the investment year: the receipt of participant 401(k) statements. For those investors who are inclined to make once-a-year adjustments in their retirement portfolios, this is when it usually happens.

Many of these annual adjustments serve as a great lesson – of what not to do. They are examples in the folly of the herd, shallow thinking and how not to make investment decisions.

A study by Andrea Frazzini at the University of Chicago and Owen Lamont from the Yale School of Management found that investor sentiment, as measured by money flows in and out of mutual funds, is a predictor of future asset class returns. Specifically, high current investor sentiment predicts low future returns.

The increasing popularity of an investment is an obviously great measure of outstanding past returns – not future ones.

By regularly reallocating their assets across different mutual funds, retail investors actually reduce their wealth in the long run.

In the words of Frazzini and Lamont, “fund flows are dumb money.”

It is easy to see how it happens: you get your year-end statement and notice that the ACME fund did better than the one you owned last year. So you move your money to ACME without much or any thought about the causes of either fund’s performance. Your decision is based on what performed best last year, with little or no meaningful analysis of what might do well in the future – and why.

In 2012, bonds extended their three decade bull market. The Vanguard Intermediate Term Corporate Bond fund, for example, increased 10.5 percent – which is better than a number of stock funds. I suspect that individual investors will move money to that fund and others like it as the result of the 2012 performance.

But why did bond funds gain so much last year – and more importantly, is it likely to continue?

Since bond prices move in the opposite direction of interest rates, most of the recent bond market performance can be attributed to a continued decline in interest rates. Most of the interest rate decline last couple of years was the result of massive bond purchases by the Federal Reserve Board.

The ten-year treasury rate declined from 3.3 percent in December 2010 to 1.8 percent in December 2012.

The Fed may continue its apparent QE forever program, but what is the likelihood that the ten-year treasury rate declines another 1.5 percentage points in the next two years?

This isn’t just about bond funds. Gold funds, other natural resources, international, internet…over and over again, investors chase the most recent big thing.

Herbert Stein, a chairman of the Council of Economic Advisers under Ford and Nixon, told us that “if something cannot go on forever, it will stop.” Investments don’t have momentum. They aren’t cars and they are not subject to Issac Newton’s laws of motion.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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