Why the stockmarket is like Love Island

Much like TV reality show Love Island, the stockmarket is a beauty contest. Matthew Partridge explains why, and how you can make it work to your advantage.

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You're not looking for the prettiest, but the one you think others will like best

Love Island is a reality TV show where attractive young couples are voted on and off by a public vote a bit like Big Brother (does anyone remember that?) but with more sun and fewer clothes. Tonight, it comes to its conclusion.

However, it's not just a bit of light summer entertainment, it is also a great metaphor for investing. Not convinced? Here's why.

The stockmarket "beauty contest"

The economist John Maynard Keynes is well known for his theories on the use of fiscal policy to keep the economy growing on a stable path. They have been hugely influential.

But what's less well known is that he was also a very successful investor. He managed the endowment of Kings' College Cambridge for over two decades, beating the market by a considerable margin, and was also on the boards of various pension funds.

Despite (or perhaps because of) his experience, he remained cynical about both the investment industry and the stockmarket in general. He famously compared the stockmarket to a casino.

In one of his most famous quotes, he compared investing to a beauty contest where "each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view".

Momentum investing, and why it works

Keynes may have been speaking slightly tongue in cheek when he said this when it came to the Kings portfolio, he pursued a contrarian approach that focused on shares that he thought were undervalued. Butmomentum investing, the idea of buying those shares that are rising in price and avoiding those that aren't doing so well, is a popular investment strategy. What's more, the evidence suggests that it has worked extremely well in the past, at least if you hold shares for only a short period.

In his book What Works on Wall Street, James P O'Shaughnessy looks at what would have happened had you had bought the top decile (10%) of shares with the highest returns in the past six months, held them for another six months and then repeated the process. He finds that for US shares, between 1927 and 2009, you would have earned 14.1% a year, compared with 10.5% for the market as a whole and only 4.2% for the worst performing decile.

Using a slightly different methodology, Elroy Dimson, Paul Marsh and Mike Staunton also found that stocks that did the best in the past six months outstripped both the wider market and the worst performing stocks over a 117-year long period. This worked for both the UK and the US.

The downsides to momentum investing

It's important to note that momentum investing doesn't always work: it does well in markets which consistently go up (or down), but it comes unstuck when trends end, or reverse.

During 2008, a momentum strategy would have saved you quite a bit of money, because it would have got you out of the worst performing sectors, such as banking, while others clung on. However, the strategy performed dismally the next year, because these shares were the ones which rallied the most. Similarly, when the technology bubble burst at the turn of the millennium, many of the previously best-performing stocks collapsed overnight.

Because of this, momentum investing tends to be a much more volatile strategy, so it is not for investors who are particularly risk averse.

Another flaw is that it works best over shorter time periods. If you want to hold stocks for more than a year, studies have shown that you'd be better off with the opposite approach of buying shares that have lagged the market ("value investing").

As a result, many momentum investors end up constantly rearranging their portfolios to get rid of the worst performers; a strategy that is closer to trading than to investing. Not only can this be time consuming but it can also be expensive, both in upfront trading costs, but also less visible costs, such as the "spread" the difference between the buying and selling price.

A momentum-investing ETF

The good news is there are several "smart beta" (or "factor") exchange-traded funds that can take much of the stress out of this approach. These funds are set up so that they only focus on those shares that are rising in price.

Because they make their buying and selling decisions on strict mechanical criteria you're not relying on the subjective judgement of a human fund manager. This also means that they also charge much lower costs than traditional active funds (though higher than the cheapest index funds).

iShares Edge MSCI World Momentum Factor UCTIS ETF (LSE: IWMO)

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