“Talent, I believe, is most likely to be found among nonconformists, rebels and dissenters”.
While this quote from advertising legend David Ogilvy was originally describing the advertising industry, it is very relevant for investors today, even 60 years after he wrote it.
Investing rewards unconventional thinking. This phenomenon is not a fluke. The reason it occurs is because future returns from shares depend heavily on their starting prices.
In turn, these are set by all market participants' actions combined rather than fixed formulas.
Ignored, controversial or unpopular shares frequently end up yielding above-average long-term returns. This is due to the potential for many investors to shift from disliking these shares to buying them.
This process of sentiment change helps drive share prices, and rewards those willing to go against the crowd initially and wait for validation.
Conversely, investing in popular shares - even those from quality companies - can lead to disappointing returns.
If these companies only produce “good” results when the market expects “fantastic” ones, the lack of new buyers and an abundance of sellers can negatively impact returns.
Durability and function
This sounds obvious in isolation but it’s actually a rare, and counterintuitive, dynamic.
For example, if nine engineering firms propose the same location and design for a bridge, it should be reassuring. The different approach of the 10th firm can normally be explained by some mistake.
Unlike with investing, the bridge’s durability and functionality is not affected by the consensus among the nine engineering firms before it is built.
Climate change may produce higher rainfall or more violent storms, but the laws of physics that determine whether the bridge will remain standing are not going to change over its lifespan.
This peculiar dynamic about investing is particularly relevant today because the trending markets of the last decade have, as is now widely recognised, created unusually high concentration within markets.
The shares that now disproportionately impact markets have to keep delivering an awful lot of future growth in order to avoid being disappointing investments in future.
This has not mattered recently and inertia combined with human nature tend to lead us to favour sticking with tried-and-tested brands or funds. After all, “Nobody ever got fired for hiring IBM”.
Convergence of the twain
For forward-thinking advisers, though, the real problem is that this concentration in markets has led to a high degree of convergence among the larger and most well-known funds.
The correlations of the 10 largest funds in the IA’s 40-85 per cent Equity sector is over 90 per cent at present for example.
Diversification is about the only free lunch in investing.
But, diversifying across the top 10 funds today achieves little in terms of practical diversification today given this cross-correlation.
