Swedroe: Beware Stars Of Investment Balls

History and solid research tell us that following the crowd is usually a bad idea.

Let’s define “popular” as being liked or admired by the general public. One might reasonably think that popularity is a good thing, right? But when it comes to investing, research shows popularity often comes with lower returns.

This correlation can sometimes result in a conflict with traditional economic theory, where risk and expected return should be positively related.

Not surprisingly, and consistent with traditional economic theory, investors dislike risk. Thus, riskier assets generally have higher returns. For example, riskier stocks have provided higher returns than safer bonds, riskier small stocks have provided higher returns than safer large stocks, and riskier long-term bonds have provided higher returns than safer short-term bonds.

Nevertheless, we have an anomaly in that riskier small growth stocks have underperformed safer large growth stocks. They have also underperformed even more risky small value stocks.

The Downtrodden Win

What, then, explains the underperformance? One explanation for this and other anomalies —offered by Roger Ibbotson and Thomas Idzorek in their paper, “Dimensions of Popularity,” which appears in the 2014 special anniversary issue of the Journal of Portfolio Management —is that there are certain characteristics that make investments popular.

That popularity induces investment, which in turn drives up prices and drives down returns. Conversely, there are securities with characteristics that make them unpopular with investors. Investors tend to avoid them, driving down their prices and increasing their expected returns.

Research in behavioral finance has provided us with numerous examples where investor preference has created an anomaly. For example, the poor performance of small-cap growth stocks (sometimes referred to as the “black hole of investing”) is explained by their popularity. Individual investors seem to have a preference for assets with a distribution of returns resembling that of a lottery ticket (positive skewness and excess kurtosis).

It turns out that many kinds of securities with low (or even negative) expected returns but also the small chance of a “jackpot” payout have poor risk-adjusted returns, and not just small growth stocks. Others “jackpot” assets include deep out-of-the-money options, IPOs, penny stocks and stocks in bankruptcy.

Inverse Relationship Between Risk And Returns

Another example of popularity relates to liquidity. Ibbotson and Daniel Y.-J. Kim—authors of the July 2014 study, “Liquidity as an Investment Style”—concluded there is an inverse relationship between returns and risk, at least in terms of volatility. They found low-liquidity portfolios (the least popular stocks) have the highest return but the lowest risk.

The bottom line is that the field of behavioral finance has delivered another insight into expected returns, besides its risk explanation. Ibbotson and Idzorek explain: “The payoff [in the form of a premium] is not just for risk but also for anything investors find to be intrinsically unattractive, for example, less liquid, high taxability, difficult to diversify, high search costs, bad management, distress, and so on.”

We see this play out in many ways. For example, Peter Lynch advised investors to “buy what you know.” This advice obviously causes investors to buy stocks with which they are familiar. But these stocks are likely to be the large growth companies and stocks in the news most often.

Confusing The Familiar With The Safe

Buying what you know often results in the mistake I refer to as confusing the familiar with the safe.

It can also be an explanation for the momentum effect. Stocks that have recently done either the best or the worst tend to be in the news. Investors jump on the “bandwagon” (buying yesterday’s winners and selling yesterday’s losers), thus generating momentum.

While acknowledging there may be many ways to define popularity, in their paper, Ibbotson and Idzorek use turnover as one measure of it. They showed that stocks with the lowest turnover (least popular) had the highest returns and the lowest risk, and the relationship was monotonic as you moved across quartiles.

Yield Is Trendy—Too Trendy

So what’s popular today? It’s safe to say that, since the Federal Reserve adopted its zero rate policy, any strategy that looks for yield certainly has become trendy. So buying riskier credit products—including junk bonds—has become more widespread, as has investing in REITs. Among the most popular, however, has been investing in dividend-paying stocks.

And the “Black Swan” that was the financial crises of 2008 led investors to seek the safety of low-volatility equities. The popularity of this strategy was fueled by research that showed low-volatility stocks had earned marketlike returns while exhibiting less than marketlike risk.

Unfortunately, popularity brings higher prices, and with them lower expected returns. This can be observed in the way that the very nature of these stocks has changed. Both high-dividend paying stocks and low-volatility stocks used to look a lot more like value stocks than they do today. The popularity of these strategies led to higher prices and lost exposure to the value premium.

Another problem is that, when a strategy becomes popular, assets are now held by “weak hands.” Weak hands are investors who are likely to panic at the very first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward 1. If you need any reminders of the danger this represents, just recall what happened to Internet stocks after February 2000.

Investing Isn’t A Popularity Contest

It’s long been known that buying what’s popular isn’t what buys you that yacht. In fact, many of the most successful investors are well-known “contrarians.”

They have an investment style that goes directly against what’s popular. And the research shows that buying what’s popular not only tends to lower returns, but sometimes it results in more risk as well. While being contrarian won’t necessarily make you popular, the evidence demonstrates that it’s likely to earn you higher returns with the possibly of no more, if not even less, risk.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.