Investment trends are like any other trend, we look around and see what else is popular and what everyone else is doing. This is called ‘herding’ because we behave like pack animals and follow by other people’s example. When it comes to investing, this causes some big problems and this article uses several examples to show how exactly chasing a trend or a ‘hot stock tip’ can be harmful. This article is curated for more of the DIY investor who thinks they will be better off listening to pundits and experts to design their own portfolio.
This might sound familiar: at a barbecue, a friend or brother-in-law (let’s call him ‘Bob’) hears about this great new investment and thinks now is a great time to invest. You listen and invest your money and then you end up with 1 of 2 results in the future; you’re either better off or worse off. It’s great if you are better off, although, the odds are stacked against you, and even professionals whose jobs rely on picking individual investments often don’t do it very well.
One of the big problems is, the appeal of any particular investment changes over time. If you returned to the barbecue a year later, the investments Bob recommends might sound different. The following year, they are different again (see the trend?). Bob is basing his investment decisions on what looked great in the past, because that’s the information available to him. He can’t predict the future, so he looks at what an investment has done over the past year, or maybe 2 – 3 years. But this shows that Bob is always chasing the returns of what has already happened, and the returns in the future could look entirely different. Returns are backward looking (past), but investment decisions are forward looking (future).
So here are 4 real-life examples. We looked at some actively managed funds, a broker firm and a media outlet to see what their top 3 ‘hottest stock tips’ were for 2018 (because that’s 5 years from 2018-2022). We took each of their 3 best ideas and assumed someone invested 1/3 into each stock tip, and that became a portfolio. This means there are 4 portfolios made up of 3 individual investments and then we compared that to a boring portfolio that is just invested in 2 funds, half invested in an ETF that tracks New Zealand’s Index NZX 50 Index and the other in the entire world’s share portfolio ETF (the index is known as the FTSE Global All Cap Index).
The Sensible Approach
Here is a portfolio that is very simple to create and manage. It is made of 50% NZX 50 + 50% in the rest of the world offered a total return of 25.04% as at 30th of December 2022. This is a compound rate of return of 4.57% each year and would’ve turned $100,000 investment into $125,040.
Result = Great
Hot Tip #1
The 3 biggest holdings this particular managed fund’s investment offering were Fletcher
Building, Spark, and Auckland Airport, back in 2018. As you can see, Spark grew 48.76% over that time, while Auckland Airport did less and Fletcher actually lost about 1/3 of it’s value over these 5 years. If you invested in those 3 equally, your portfolio would have grown 11.40%, which is not much, especially compared to the 2-fund sensible portfolio. You’re $100,000 invested would only be $110,400 larger after 5 years.
Result = worse
Hot Tip #2
The next is a media outlet that wrote an article back in the
day and their top 3 choices were A2 Milk (lost -8.55%), Air New Zealand (which lost -61.79%) and Xero (impressive 147.87%). The total 1/3s portfolio would have grown 25.84% which is better, but it had higher risk.
Result = good
Hot Tip #3
The third recommendation came from a investment firm and their best forecasts for 2018 which were Tourism Holdings (-42.24%), Restaurant Brands (-21.23%), and Meridian Energy (61.84%). This portfolio would have returned 5.13% taking $100,000 to about $105,130.
Result = not good
Hot Tip #4
The top 3 investments here were A2 Milk, Auckland Int’t Airport, and Fisher & Parkel Healthcare. This portfolio saw a total gain of 23.14% over the last 5 years, turning $100,000 into $123,140 which is only slightly under the Sensible
Portfolio.
Result = not horrible
Putting This All Together
In conclusion, one of these pundits beat the benchmark by a slight edge, one other came close but fell behind a little, the other 2 really weren’t worthwhile. The other thing that is interesting is that many of the people that make ‘stock tips’ change them each year, so it’s unlikely they would keep the same holdings over 5 years, even though that’s a better strategy.
The odds that someone will be able to pick the right ‘prophet’ or ‘stock picker’ is low (less than 25%), but then they have to follow that recommendation and keep it for the long term. That sounds easy but what it means is that our investor example from earlier, Bob, he has to avoid selling those investments when times get tough! If you think that’s easy, give it a try and don’t fiddle with your portfolio over the next few years or even decades.
One of the biggest issues comes down to the fact that holding 3 shares that are only invested in NZ, is not a diversified portfolio. This means that ¾ of the above examples, the investor would have had a higher balance in a boring portfolio, but they also would have had significantly less risk. The amount that a portfolio will fluctuate from 3 companies can be massive, and many investors simply are not prepared to watch their $100 go to $1,400 and then back down to $60. It’s painful to live through that. Imagine if the stakes were higher and someone was investing $1,000,000. How would that feel to see $300,000 lower after 5 years of investing?
Diversification means that returns tend to be smoother over time (You can read more on that here). The more diversified a portfolio is, the less it tends to swing up and down,
because if 1 share/holding goes down and it is worth 1/3 of everything in a portfolio, that’s way bigger than a diversified portfolio where 1 share/holding represents .0023%.
The portfolios mentioned above are all concentrated (the opposite of diversified) and suffer from higher volatility and swings in value. This is generally what advisers call ‘risk’ (it’s also referred to as ‘volatility’). So even an investor that does get a higher return, has also taken on more risk. There are 2 sides to risk, when it works out well, we are happy because our money grows, but when it doesn’t work, we feel those losses as pain.
If we extended this out to a 10-year history (or checked it again 5 years from now), my guess is that the boring portfolio would look even better compared to the others, because low-cost diversified portfolios tend to do better than stock picking, especially when you give a longer time frame. The more time given, the better boring portfolios do. All of these reasons are why the Sensible Portfolio is the real winner, even though it was outperformed a little by one of the options. It’s easy, available to invest in for anyone, it’s low-cost, diverse, lower volatility (risk) and is evidence-based.
So, chasing investing trends is a fool’s errand. While it can work for some investors, most will not win as much as they could by going with a tried-and-true method of diversifying into low-cost options, and using someone that will help them stay on track.
If you enjoyed this, here are some other related resources:
You can always do this yourself by plugging in a portfolio to Google Finance and seeing what the historical returns are and how they compared to each other. This article was written in early October 2022, and performance results will vary depending on when someone looks at the performance.
Here’s an article that discusses a similar story for a famous fund (ARKK) run by Portfolio Manager Cathie Woods and explains how the investment has done well, but most investors have lost money anyway.