Tuesday, October 18, 2005

Extraordinary Popular Delusions

Before spending my days sitting in pyjamas blogging, I worked in the financial markets. I was sharply reminded of this by Matthew D'Ancona's excellent article pointing out the parallels to the leadership contest:

'The frenzied Tory marketplace fizzes with fear: prices soar and crash. Traders adjust their positions by the hour.

The reaction to Davis's speech at Blackpool was hysterically hostile; the reaction to Cameron's performance was hysterically positive. What exactly was Cameron selling? It did not matter: people were buying. I was reminded of the South Sea Bubble and those who invested furiously in the scheme "for carrying on an undertaking of great advantage, but nobody to know what it is".

One of the best books about crowd hysteria is Charles Mackay's 1841 classic Extraordinary Popular Delusions And The Madness Of Crowds:

'We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first.'

We don't really need Mackay to tell us that such hysteria never ends well, but it's a great read.

And this idea lies behind one of the most powerful concepts in investment- the distinction between growth and value.

Growth is forward looking, exciting, and there's always a compelling crowd-pleasing story. It's the future not the past, and investors in growth stocks are going with the flow. They really "get it"- even if "it" may sometimes be a little vague- and they are invariably feted by the financial media. Little wonder: as the crowd catches on the prices of favoured growth stocks can soar, and I mean soar: I once knew a guy who much to the delight of his colleagues, bought a couple of grand's worth of IT stock and saw its value reach a cool mill in just a few short months.

Value on the other hand is dull. Dull, dull, dull. Value investors spend their days pouring over company accounts trying to find good solid companies that are out of favour with the crowd. Short-term returns are never that spectacular, and people are always asking why they are invested in such dull problematic companies. Value investors stand apart from the crowd, and frankly, it never actually feels that good.

The strange thing is though, that over the long-haul, value outperforms growth. For example, in the UK, those dull value stocks have outperformed exciting growth stocks by about 300% over the last five years.

Growth is a rollercoaster, which can produce spectacular returns during say an internet bubble, but then has a horrible tendency to plummet earthwards and smash to smithereens on the concrete below. Thus my erstwhile millionaire colleague held onto his brilliant investment just a little too long , and saw it all disappear (obviously the rest of us were overjoyed).

Now, does any of this sound at all familiar? Or have I bored you to death?

Just remember this: beware popular delusions- however widespread they are.
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