Advertisement

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.

180730-love-island
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.

Advertisement - Article continues below

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.

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

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)

Advertisement
Advertisement

Recommended

The British equity market is shrinking
Stockmarkets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
Share tips of the week
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
7 Aug 2020
The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”
Investment strategy

The MoneyWeek Podcast: how to age well and profit from the “longevity dividend”

Merryn talks to economist and author Andrew J Scott and discusses how we can profit from the "longevity dividend" as we live longer; why we need to re…
6 Aug 2020
Three mistakes to avoid when investing on Aim
Small cap stocks

Three mistakes to avoid when investing on Aim

Investing in Aim shares can produce spectacular returns. But as Michael Taylor of Shifting Shares explains, you have to have your wits about you.
5 Aug 2020

Most Popular

Don’t despair on dividends – these companies could be set to bring them back
Income investing

Don’t despair on dividends – these companies could be set to bring them back

The value of dividends paid out by UK stocks has plummeted this year as companies “rebase” their payment policies. But things could soon start to look…
6 Aug 2020
Platinum: the precious metal that looks set to play catch-up with silver and gold
Silver and other precious metals

Platinum: the precious metal that looks set to play catch-up with silver and gold

Gold and silver continue to soar, but there's still time to get in. And there's another precious metal that looks set to go on a bull run too, says Jo…
7 Aug 2020
Eagle Lightweight GT: the reincarnation of the E-type Jag
Toys and gadgets

Eagle Lightweight GT: the reincarnation of the E-type Jag

Jaguar’s classic E-type sports car has been reinvented for the modern age. The result – the Eagle Lightweight GT – is a thing of beauty.
7 Aug 2020