Why it pays to bet against the crowd

Contrary to received wisdom, past returns could indeed be a useful indicator for future performance - but only in reverse. Tim Bennett explains.

Every fund investor is familiar with the standard warning that past returns are no guide to future performance. But a piece of research from information provider Lipper suggests this isn't strictly true. Past returns, notes The Economist, can in fact be useful "if only as a contrarian indicator".

Lipper looked at British funds between 1983 and 2012. For each given year, the researchers took the best-performing, median, and worst-performing British fund sectors. It then looked at the performance of these sectors over the following one, three and five-year periods.

There were two clear conclusions. In the short term, you should chase the outperformers. The top sector in one year tends to outperform the median and bottom sectors for up to a further three years. But if you're looking to the long term, you want to pick the worst performer: after five years, this will tend to have beaten both the top and median options.

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In short, investing against the crowd being a contrarian pays over longer periods of time. And since funds should be mid-to-long-term investments, that's the finding that really matters.

Why does it happen? Two different forces explain these findings on short-and longer-term fund performance: momentum' and reversion to the mean'. The momentum effect is self-explanatory. Investors see one fund doing well, so they pile into it in the hope that it will continue to do well.

What does the fund manager do with all this new client money? He tries to prolong his success by pumping even more money into the same stocks and sectors he already holds. Even when those stocks have ceased to be good value, the sheer volume of money chasing them keeps them riding higher. Meanwhile, money leaves assets that have been left out of the spotlight, driving their prices lower.

However, in the longer run, mean reversion' kicks in. Put simply, each asset class from equities, to bonds, to property will eventually try to get back to somewhere near its long-term trend valuation. If an asset is too expensive, or too cheap, compared to its fundamentals, then this will eventually correct, once the momentum effect dissipates.

What was once hot such as bank stocks before the recent crisis, or dotcom stocks at the end of the 1990s suddenly is not. Investors wake up to reality and overpriced assets get dumped en masse. Yesterday's star fund manager becomes today's pup.

So what should you do now? In 2012, the smaller companies sector was the top performer. Momentum could carry it still further this year, but a contrarian should have one eye on the door. Meanwhile, the sector that's been in the doldrums for the past five years is commercial property.

According to the Financial Times, the IMA property sector lost 16.88% between February 2007 and February 2013. With sector investment flows positive for the first time in December in ten months, property could be about to "come in from the cold".

Three ways to be a better contrarian

Being a contrarian sounds easy. But clearly it isn't, or else everyone would do it, and it wouldn't work anymore. The trouble is, "it's really hard to sell when we're euphoric or buy when we are terrified", as Robert Seawright, CIO of Madison Avenue Securities, notes on his blog. Here are three tips for short-circuiting your emotions and becoming a more systematic contrarian.

Focus on data, not stories. Be prepared to roll your sleeves up and do some number crunching, or at least ensure you understand and can check numbers that others have crunched for you. Any investor who isn't familiar with at least the basic investment ratios will too easily fall for hype.

Process is everything. Successful investing is repetitive, systematic dull, even. If not, then it's easy to get caught up in other people's buying or selling decisions, rather than making sober-minded judgements of your own. So work out how often and how much you will invest. Have a plan for when to take profits, or cut losses, and for how often you will rebalance' your portfolio (where you examine your holdings to ensure your asset allocation hasn't moved too far away from your desired weightings).

Also, when you invest in an asset, make a note of your rationale for doing so there and then, so that later you can decide whether your original reasoning ("it was unduly cheap") still stands. And never forget losses note why they happened. If you can't explain why, your reasons for investing in the first place cannot have been very sound.

Take the opposite side. Every time you buy a share, someone else is selling. Do they have a point? What if you had to write a sell' note on the stock could you do it? Would it stack up? If you find this process fairly easy, then maybe it's not as much of a buy' as you'd thought.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.