Why you should avoid the comfort of investing with the herd

So, if everyone expects a company to grow, then its share price might be too expensive?

Tye Bousada: When you make an investment in the stock market there are only two potential outcomes – you’re either making a mistake or capitalizing on someone else’s. Your relative gain will be someone else’s relative loss, or vice versa.

How do you increase the probability of being the one to win in this equation? The answer is you must have a view about the business’s future that’s not currently reflected in its share price.

Said differently, you should know why the business you’re investing in will be bigger in the future than the market currently believes. If you can’t answer that question, you’re likely making a mistake investing in it.

But that sounds like it could be an uncomfortable choice?

Tye Bousada: Here’s the problem with doing what makes you feel comfortable. You aren’t unique. As such, most people are doing the exact same thing you are – in this case, seeking the comfort of the obvious growers in the stock market. This “herd mentality” results in rising valuations.

Growth stocks make the average investor feel comfortable today because they’re going to grow in this volatile world. This comfort causes people to invest in them despite not having a view on how the business might help them achieve their goal.

Although owning an obvious growth stock makes you feel comfortable today, overpaying for a business because it makes you feel comfortable in the short-term won’t help you get there.

You’ve always maintained that it’s unwise to overpay to invest in big, growing companies that are expensive compared to the rest of the market. What does that mean?

Tye Bousada: If they’re brave enough to wade into the stock market, what most people have felt very comfortable doing over the last 12 to 18 months is find the obvious growers. People are looking for the simple narratives, the very big mega-cap businesses. And they’re not really paying attention to valuation.

But that’s never proven to be a successful strategy. Let me add some colour to that. Go back over the last 70 years, and in every year look at the 750 largest businesses in the United States, and then pull out from that list the 10% fastest growers. Compare those fastest growers to the average valuation of the rest of those big companies.

You might be surprised to know that people have never paid more on a relative basis for growth than they have over the last 12 months; and that includes the “dot-com bubble” back in 2000.

If you look at other time timeframes where people have paid a lot for growth relative to the rest of the market, it’s never ended well. That seems to be what’s going on in the market today.

Finally, do you see any parallels with the current popularity of index-tracking ‘passive’ funds, which allow people to invest across whole markets or sectors?

Tye Bousada: It all comes back to whether doing what feels comfortable today is the right thing in the long-term. Let me quickly walk you through 50 years of people doing what made them feel comfortable in the short-term, only to see a permanent loss of capital in the long-term.

I was born into the era of the “nifty 50”, a time in the United States where investors thought that all they had to do was buy the 50 biggest, most branded companies that were the obvious growers. That made everyone feel comfortable. But had they done that, over the next decade they would have experienced permanent loss of capital. They would have seen their money cut in half.

Then, in the late 1970s, President Jimmy Carter went on television and told his fellow Americans that the world would soon hit peak oil. Everyone went out and bought oil and gas companies – in fact, I know families that buried tanks of oil in their backyard as an investment. However, 25 years later it cost them more money to pull that tank out of the ground than the oil inside was worth – there was permanent loss of capital again.

In the 1980s, the idea was to invest in Japan, because everyone would soon be buying Walkmans and televisions from Sony, and Toyota was going to teach the rest of the world how to make cars. It might have made you feel comfortable at the time to do it, but 30 years later and you’ve still not made your money back, never mind having accounted for inflation.

In the 1990s, the narrative was that emerging markets always grow faster than developed markets. But that decade saw crises in Mexico, Russia, and South-East Asia, that resulted in permanent loss of capital. In 1999 it was technology, media and telecoms, which everybody ploughed into. And we all know how that ended.

Finally, in the mid-2000s, there was a real estate boom going on around the world. Alan Greenspan, then-Chair of the US Federal Reserve, went on television and told Americans they had nothing to worry about, because the average house price in the United States never goes down. Again, people felt comfortable following these ideas.

So, I understand that a lot of people might feel comfortable buying an index fund that’s chock full of mega-cap businesses trading at all-time high relative valuations. But if history is a guide, that will not prove to be a strategy that gets people towards their financial goals.

EdgePoint are co-managers of the St. James's Place Global Equity and Global Growth funds.

Where the views and opinions of our fund managers have been quoted these are not necessarily held by St. James's Place Wealth Management or other investment managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice.

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