In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 36: Fashions and Investment Folly.

LEARNING: Do not be swayed by herd mentality.

 

“Markets can remain irrational longer than you can remain solvent. So do not bet against bubbles, because they can get bigger and bigger, totally irrational eventually, like a rubber band that gets stretched too far, it snaps back, and all those fake gains that weren’t fundamentally based get erased and investors get wiped out.”Larry Swedroe

 

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 36: Fashions and Investment Folly.

Chapter 36: Fashions and Investment Folly

In this chapter, Larry explains why investors allow themselves to be influenced by the herd mentality or the madness of crowds.

Perfectly rational people can be influenced by a herd mentality

When it comes to investing, otherwise perfectly rational people can be influenced by a herd mentality. The potential for significant financial rewards plays on the human emotions of greed and envy. In investing, as in fashion, fluctuations in attitudes often spread widely without any apparent logic.

Larry notes that one of the most remarkable statistics about the world of investing is that there are many more mutual funds than stocks, and there are also more hedge fund managers than stocks. There are also thousands of separate account managers. The question is: Why are there so many managers and so many funds?

Effects of recency bias

According to Larry, there are several explanations for the high number of managers and funds. The first is the all-too-human tendency to fall subject to “recency.” This is the tendency to give too much weight to recent experience while ignoring the lessons of long-term historical evidence. Larry says that investors subject to recency bias make the mistake of extrapolating the most recent past into the future, almost as if it is preordained that the recent trend will continue.

The result is that whenever a hot sector emerges, investors rush to jump on the bandwagon, and money flows into that sector. Inevitably, the fad (fashion) passes and ends badly. The bubble inevitably bursts.

Investment ads create demand where there is none

Another reason, Larry notes, is that the advertising machines of Wall Street’s investment firms are great at developing products to meet demand. The record indicates they are even great at creating demand where none should exist.

The internet became the greatest craze of all, and internet funds were designed to exploit the demand. Investors lost more fortunes in the craze. The latest fashions include cloud computing, electric vehicles, and artificial intelligence.

However, this trend, at least for mutual funds, has changed, and there are now fewer funds than there were at the height of the internet frenzy. This is a result of many poor performers being either merged out of existence (to erase their track record) or closed due to a lack of sufficient funds to keep them operational.

Inconsistent performance by active managers

Another reason for the proliferation of funds is that Wall Street machines recognize active managers’ track records as inconsistent (and often poor) performance. Thus, a family of funds may create several funds in the same category, hoping that at least one will be randomly hot at any given time.

How to beat herd mentality

To overcome herd mentality, Larry advises investors to craft a comprehensive investment plan that factors in their risk tolerance. By building a globally diversified portfolio and sticking to this plan, investors can navigate the market’s noise and emotional triggers, such as greed and envy during bull markets and fear and panic during bear markets.

He also adds that investors will benefit more from using passively managed funds to implement the plan; this is the only way to ensure they do not underperform the market. Minimizing this risk gives them the best chance to achieve their goals. If investors adopt the winner’s game of passive investing, they will no longer have to spend time searching for that hot fund. They can spend time on far more critical issues.

Further reading

1. Charles MacKay, Extraordinary Popular Delusions and the Madness
2. Quoted in Edward Chancellor, Devil Take the Hindmost, (Farrar, Straus and Giroux, 1999).

Did you miss out on the previous chapters? Check them out:Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform

• Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
• Enrich Your Future 02: How Markets Set Prices
• Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
• Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
• Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
• Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
• Enrich Your Future 07: The Value of Security Analysis
• Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return
• Enrich Your Future 09: The Fed Model and the Money Illusion

Part II: Strategic Portfolio Decisions

• Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
• Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill
• Enrich Your Future 12: When Confronted With a Loser’s Game Do Not Play
• Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance
• Enrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon
• Enrich Your Future 15: Individual Stocks Are Riskier Than You Believe
• Enrich Your Future 16: The Estimated Return Is Not Inevitable
• Enrich Your Future 17: Take a Portfolio Approach to Your Investments
• Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans
• Enrich Your Future 19: The Gold Illusion: Why Investing in Gold May Not Be Safe
• Enrich Your Future 20: Passive Investing Is the Key to Prudent Wealth Management

Part III: Behavioral Finance: We Have Met the Enemy and He Is Us

• Enrich Your Future 21: Think You Can Beat the Market? Think Again
• Enrich Your Future 22: Some Risks Are Not Worth Taking
• Enrich Your Future 23: Seeing Through the Frame: Making Better Investment Decisions
• Enrich Your Future 24: Why Smart People Do Dumb Things
• Enrich Your Future 25: Stock Crashes Happen—Be Prepared
• Enrich Your Future 26: Should You Invest Now or Spread It Out?
• Enrich Your Future 27: Pascal’s Wager: Betting on Consequences Over Probabilities
• Enrich Your Future 28 & 29: How to Outsmart Your Investing Biases
• Enrich Your Future 30: The Hidden Cost of Chasing Dividend Stocks
• Enrich Your Future 31: Risk vs. Uncertainty: The Investor’s Blind Spot

Part IV: Playing the Winner’s Game in Life and Investing

• Enrich Your Future 32: Trying to Beat the Market Is a Fool’s Errand
• Enrich Your Future 33: The Market Doesn’t Care How Smart You Are
• Enrich Your Future 34: Embrace the Bear: Why Market Crashes Are Your Silent Ally
• Enrich Your Future 35: Market Gurus Are Just Expensive Entertainers

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

 

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