Why a herd mentality reduced returns

In their work Does Portfolio Rebalancing Help Investors Avoid Common Mistakes, Steven Beach and Clearance Rose looked at investors who chase performance, in other words, put more money into high-performing funds.  They then compared them to people who rebalanced away from the winners into the losers.

To save you time and the boredom of reading their work, I will summarize it here:

  • Investing decisions driven by normal human behavior can have a devastating impact on long-term wealth accumulation.
  • Three common behavioral issues affecting investing are examined: herd mentality, regret aversion, and mental accounting. These behaviors often result in investors “chasing” performance.
  • The authors compared a “chase portfolio,” based on the previous year’s best investment return segment, with a series of annually rebalanced portfolios using different allocations. They used three asset classes: large company stocks, long-term corporate bonds, and Treasury bills.
  • The study first compared the two investing styles, chase and rebalance, based on returns of the three asset classes from 1926–2002. The chase portfolio had a lower Sharpe ratio than almost all of the rebalanced portfolios, and it did not generate sufficient additional returns to compensate for the higher risk.
  • Only when allocation to stocks dropped lower than 25 percent did the chase portfolio outperform the rebalanced portfolio. The study found that even conservative investors shouldn’t allocate less than 45 percent to stocks, a portfolio that had the highest Sharpe ratio.
  • The study then examined the contrasting portfolio styles using rolling 20-year periods. Similar results were found: the chase portfolio outperformed the rebalanced portfolio only when the rebalanced portfolio’s stock allocation was lower than 25 percent.
  • Even for the 20-year period ending in 2002 with two devastating stock years, and where the chase portfolio would have done well because of bonds, the rebalanced portfolio provided slightly better returns.

There you have it.  If you have a simplified, well-diverisifed portfolio of global stocks and bonds, it makes a lot of sense to rebalance once a year or every 6 months. Human nature, unfortunately, wants to do the opposite, and invest more in the winners.

There is a simple reason for this. Today’s winners are seldom tomorrow’s, and as discussed before, it is almost impossible to forecast tomorrow’s winners.

Human nature also has a herd mentality as the authors stated.  It really is amazing how many people out there believe that property, or even gold, has outperformed markets when the evidence is put there for all to see!

Adam Fayed – International AMG – adamfayed@iamgltd.com

Blog Comments

I tend to agree with the last statement with a possible caveat; if you take the time to properly evaluate property (buy, rehab,sell,) there is
a profit potential substantially above 6-6.5% APR. That said, you will need 50-150k (my opinion) to start this operation. The problem is to avoid the effects of carrying inventory and waiting too long for a sale. I know, I know, not everyone can look for property and work a full time job, but there a better return awaiting those who will take the time to follow some simple steps. You have to know your market and stay close to home.

Yes that is right Bill. Property can beat stocks but it needs to be leveraged, to beat it long-term, or use other strategies. Certainly more risky and time consuming than a liquid portfolio.

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