Curing the curse of the bandwagon effect before the next crisis

CHICAGO Fri Jan 25, 2013 1:10pm EST

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CHICAGO (Reuters) - During a market crisis, when everyone wants to jump off the ship in the same leaky lifeboats, that doesn't bode well for most individual investors, who simply want to preserve capital.

The safeguard is to move against what behavioral finance experts call the "bandwagon effect" -- when so many investors follow the same path that they disrupt the traditional correlation of assets.

This is what has happened when Modern Portfolio Theory (MPT) -- a bedrock of investing that advocates diversifying your portfolio to temper risk and boost returns -- met big institutional investors who employed the idea on steroids, plowing money into alternative investments from leveraged hedge funds to timber.

In his new ebook "Skating Where the Puck Was: The Correlation Game in a Flat World," William Bernstein, a money manager and neurologist, credits the surge of going big with MPT to David Swensen, the legendary manager of the Yale University Endowment. His strategy of deploying more than half of the college's portfolio in alternative assets such as timber, hedge funds, private equity and commodities produced a 15.6 percent annualized return between July 1987 and June 2007, besting the benchmark S&P 500 by nearly 5 percentage points.

At the time, Swensen's success upended the ossified standard practice of 60 percent stocks, 40 percent bond mixes. Seeing that they could do better, money managers with significant resources parroted Swensen's allocations. By the mid-2000s, more than 800 large endowments and pension funds were mimicking Swensen.

Yet emulation isn't the same as duplication. As everyone jumped on the bandwagon of highly illiquid alternatives, returns began to lag market benchmarks. By mid-2011, Bernstein found, most endowments couldn't beat common gauges like the S&P 500. Hedge funds, which also had a great run until the second decade of the 21st Century, also started to become expensive laggards. The bloom was off the rose.

The great alternative investment bandwagon effect surfaced in a nasty way in 2008, when nearly every non-bond investment followed stocks down in the most horrendous slide since the Great Depression. Investors were shocked to discover that assets they counted on as hedges to move in the opposite direction of stocks instead went down the drain at the same time.

What happened then? Big investors panicked en masse and dumped their riskiest assets simultaneously. Fear united the horde. Government bonds, in contrast, stayed in positive territory, because they were the only remaining safe havens. In the interim, Swensen's Yale strategy suffered along with everyone else holding alternatives: The university's portfolio lost about a quarter of its value in 2008-2009.

HOW TO COUNTER

Bernstein, who has often taken a combined empirical and common sense approach to managing money, argues that to counteract such bandwagon effects, investors need to avoid chasing the big boys on that latest alternative investment such as hedge funds.

While diversification is never a bad idea, it is wise to accept its limits and to gauge your total portfolio risk, which is the sum of its parts.

One thing to consider is that when you see the stock market collapse, it is too late. So Bernstein suggests in his book that if you see that credit's becoming tight, you get rid of your risky assets -- all of them -- and instead go for comfortably government-secured vehicles. This may be difficult for most people to track, so pre-determine the amount of risk you can take and lower risk through diversifying into bonds, money-market funds and federally insured vehicles.

It is also valuable to keep track of when the bandwagon is getting wobbly. "I watch who's owning given asset classes," Bernstein said via email. "When everyone owns them, like commodities and the SPDR Gold Trust (GLD) today, their future correlations will most likely rise."

Where the rubber meets the road is translating potential losses into terms you can understand in your real life, not just numbers on a balance sheet. For instance, ask yourself if you were to take a 20 percent loss, would you be able to retire comfortably? Does a 40 percent loss keep you in the job force for an extra five years, instead of allowing you to retire when you want?

Still, you can continue to diversify as long as you understand the risk/return nature of what you're investing in. Assets can become un-correlated when markets function in non-crisis modes. It's still possible to make money in emerging markets when European stocks are flat or negative. Bonds still offer protection against stock losses. Precious metals, real estate and commodities may confer some upside during inflationary periods.

The key to preserving and growing your wealth is to watch -- and avoid -- the bandwagon as much as possible and find the portfolio medley that works best for you. Sometimes, as Bernstein has well noted, there's no safety in crowds.

(The author is a Reuters columnist and the opinions expressed are his own.)

(Follow us @ReutersMoney or here Editing by Beth Pinsker and Andrew Hay)

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