Is Indexing the Answer to Herd Investing?

That investors buy at the top and sell at the bottom is a sad truth that has been well-established as typical financial behavior. A column in today’s Wall Street Journal raises the question: what should investors do about that?

The usual answer is to argue for indexing — if we “can’t” beat the market, we might as well join it. But the Journal’s Brett Arends says the better answer is to bet against the herd: when the market is going up, get out. When it’s going down, buy.

The impetus for the piece is a new study by TrimTabs Investment Research, which shows that over the last decade, while the overall market was relatively flat, average investors lost big — $39 billion is their tally. “Mutual fund investors bought into the Standard & Poor’s 500-stock index at an average of 1,434,” Arends writes, “close to its record high of 1,565. If investors had invested at random times instead, their average purchase price would have been 1,171.”

According to the TrimTabs report:

About half of the past decade’s U.S. equity mutual fund investors are sitting on paper losses of more than 25% even though the S&P 500 stands exactly at its 10-year average. As a result, some mutual fund investors are so deep underwater that rallies are essentially meaningless to them. Also, many investors might be selling simply to harvest losses on their underwater positions.

Arends argues:

The TrimTabs numbers show… that over the past decade it was actually quite easy to time the market. All you had to do was buy when the public was selling, and sell when the public was buying.

Easy enough to do, he notes. Just track the Investment Company Institutes’ report on fund flows, and do the opposite.

There’s evidence, however, that we may be getting better at controlling our own bad instincts.

In March, DALBAR, Inc., the Boston research firm which has some of the richest data on investor behavior, reported that equity fund investors actually beat the index in 2009, earning more than the S&P 500. According to DALBAR, equity fund investors made 32.20% in 2009, compared with 26.45% for the S&P 500.

That study showed that over the prior 20 years, equity fund investors did sharply lag investors who bought and held the market (i.e., the S&P 500). But that gap has been narrowing in recent years. In 1998 there was a 10.65% difference in returns. By 2009 that had shrunk to 5.03%, the firm reports.

Of course 5% is still significant, but this might be a sign that we’re learning. And if we are, that betting against the herd may hold a diminishing return.

Where do you come out on this debate — is contradicting the herd the way to go, or indexing?

5 thoughts on “Is Indexing the Answer to Herd Investing?

  1. J. Weyant

    I personally am not one for surrendering to the index, but trying to beat the market is not for the feint of heart (or for those without money they can afford to loose). And the Oracle of Omaha has been doing pretty well by contradicting the herd for years. Still one of my favorite Buffet quotes, ““When the market gets greedy, you get scared and when the market gets scared, you get greedy!”

  2. John Kennedy

    Nanette,

    Do you have a twitter site, you should? I’d rather get updates that way. FYI, my twitter site is tradingwell.

    Regards, John.

  3. Dirk Digglesby

    I agree. Its all about action. You got trade with an itchy finger, and be nimble. Ill admit, my grandmother who has been indexing for the last 20 years has smoked my returns as an active trader and buyer of actively managed mutual funds, but that doesnt mean i shouldnt try. One of these days ill beat mr. market…..If i dont go broke first.

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