Following the crowd and chasing winners can lead to losses. But one strategy to maximise profits from investments is to opt for funds that are underperforming.
In the markets, betting on a loser could bring a windfall
Following the crowd and chasing winners can lead to losses. But one strategy to maximise profits from investments is to opt for funds that are underperforming, although such a practice may be contrary to many investors' natural instincts. Harvey Jones reports
Everybody loves a winner. That's why investors flock to stocks and funds boasting strong recent performance, in the hope that their winning streak will continue.
Time and time again, that winning streak has come to an end, often in spectacular fashion, leaving baffled investors to nurse their losses instead.
The most dramatic example was the dotcom boom of the 1990s, when private investors poured millions into soaring technology funds and online start-ups, only to buy into a blistering crash.
Backing investment winners is different to backing, say, a sporting winner. In sport, success often breeds success. With investments, it has a habit of breeding failure. A fund that has risen 50 per cent or 100 per cent in a year will find it incredibly difficult to repeat the same trick the next year.
The time to invest in a fund is before it rises in value. Many investors get things the wrong way around.
So instead of backing winners, you should consider hunting for losers. It is called contrarian investing - and it may be a better way of making money than following the crowd.
If you want to be rigorous about it, you could consistently sell the winners in your portfolio and buy losers.
Steve Gregory, the managing partner of Holborn Assets, a Dubai-based financial services company, does just that and says it has worked for his clients.
"To maximise profits, investors need to buy low and sell high," Mr Gregory says. "If you are constantly chasing last year's winners, you are buying when the price is high rather than low. It may rise further, but there is also plenty of downside and you might end up selling low."
Investment sectors are subject to the vagaries of fashion. Commodities are currently in vogue, but they could quickly fall out of style. China has been in for years, but as it struggles to keep the lid on inflation, it isn't as hip as it used to be.
Smaller companies have also been hot, but now the investment-fund fashionistas are hinting that big blue chips are once again the cool kids on the block.
It is hard to keep track of trends, but you should really avoid chasing last year's model. Ideally, you need to get in on the next big craze - before it happens.
Mr Gregory says investors should start by building up a balanced portfolio of funds covering different countries, regions and sectors. You might have a selection of funds investing in, say, the US, Europe, Asia and Latin America, topped up with a few specialist sectors, such as high-income commodities, health care and technology.
For added diversification, you can direct some of your portfolio into cash, bonds and property.
This is what independent financial advisers call asset allocation and the advantage is that when one market or sector slides, another is likely to rise in value to compensate.
Setting up an asset-allocation model is only the beginning, Mr Gregory says. "You also need to review it regularly and this is when you have to start selling your winners and backing your losers."
Say you have 10 funds in your portfolio, diversified across several sectors and markets. "After six months or so, performance should start to diverge. At this point, I would rebalance the portfolio by automatically selling a chunk of the best-performing fund and investing it into the worst-performer. That way, you are selling high and buying low."
One reason they call it contrarian investing is that it is contrary to many investors' natural instincts. The temptation is always to throw more money at the winners and drop the stragglers. That's what football managers do. But it doesn't work for fund managers.
The problem is that last year's star performer is rarely next year's winner, Mr Gregory says. "More often than not, the opposite happens. Time and again I have seen markets that perform badly one year suddenly top the table a year later. That's why we consistently realign our portfolios, to maximise the chances of making money and minimise risk."
Mr Gregory says his approach isn't infallible - you have to be aware of the "dogs". This is industry slang for funds that consistently underperform the market, year after year, and if any of your funds are consistently barking up the wrong tree, you eventually have to put them down.
So why do winners find it so hard to repeat the trick? You can partly blame it on the business cycle. Commodities, for instance, are famously cyclical. Broadly speaking, oil and copper prices rise when the global economy is rising and industrial demand grows, and sink when the world goes into recession. If you buy at the top of a commodity bull run, you could soon find yourself at the bottom of the next commodity bear market.
Another challenge is that money often floods into a successful sector, forcing share values higher until they become overpriced and poor value, and the only way is down.
Several years of successful growth creates its own problems. Just look at China, which is desperately trying to cool its turbocharged economy before it overheats.
The danger with ditching your most successful investments is that their winning streak may last longer than you expect, says Mark Dampier, the head of research at the British financial advice firm Hargreaves Lansdown. "Any investment that goes up a lot will also have a lot of downside, but that doesn't always mean the trend will stop. Emerging markets such as Brazil, Russia, India and China have enjoyed years of success, and commodities have risen three years in a row. Sometimes you have to run your winners because they can deliver the goods for much longer than you think," Mr Dampier says.
Similarly, last year's loser isn't automatically this year's winner. "You only have to look at Japan to see that a market sector can underperform, year after year."
Mr Dampier says investors should review their portfolios regularly, with a view to rebalancing them. "When one fund or sector has performed very well, you can end up with a lot of money invested in a single area. You may be overexposed to emerging markets, for example. This could make your portfolio more risky than you think and you might have to sell some of your winners to rebalance it."
You should always be wary of jumping onto a bandwagon too late. "The commodities cycle has to end at some point and now looks vulnerable to a short-term sell-off. If you are overweight in commodities, you should consider more defensive areas. You could return to commodities after prices have fallen because, in the long run, robust demand from emerging markets should spark a strong recovery," he says.
If you are keen to test the theory by investing in an out-of-favour sector, Mr Dampier recommends health care and pharmaceutical companies. You can access them through equity-income funds, which invest in large dividend-paying blue-chip stocks. "High-yielding large caps did very well a decade ago, but they haven't done so well lately. Now could be a good time to invest in them."
Neil Woodford, a fund manager who runs the hugely popular Invesco-Perpetual Income and High Income funds, is also tipping pharmaceuticals. He says valuations are as attractive as he has seen in the past 25 years as a fund manager, "a career-type opportunity that doesn't come along very often". His favourite stocks include AstraZeneca, Roche and Novartis.
More than most managers, Mr Woodford has demonstrated the pros and cons of being contrarian. He famously stood aloof during both the dotcom boom and the banking bubble, enduring heavy criticism as his funds underperformed for several years, before being triumphantly vindicated.
Mr Woodford is at it again. He has been cool on rapid-growth "momentum" sectors such as mining stocks and mid-caps, because he believes the current market rebound can't last. Instead, he has targeted defensive pharmaceutical, tobacco and telecoms stocks.
His funds have underperformed for the past two years, but could this now make a good time to buy? Perhaps.
Backing losers can make sense for another reason, says Clem Chambers, the founder of Advfn.com, a stocks and shares website. "A lot of investment funds perform much better when they are smaller. It is easier for a manager to invest, say, £50 million [Dh300.6m] than £500 million. Once a small fund starts to outperform, it attracts a flood of investor money, which the manager has to invest somewhere, even if they have used up their best ideas. Invariably, performance starts to slide."
He says it often makes sense to exit small investment funds before they get too unwieldy and switch to a smaller and hungrier fund.
Some investors try to safeguard success by signing up to the cult of the star fund manager, buying funds managed by the celebs of the fund world, who have track records of beating the market.
But even the biggest stars have limited powers, Mr Chambers says. "The best managers in the world can't make money if their sector is falling. Look at technology. When the dotcom crash came, the good managers were buried alongside the bad."
Targeting out-of-favour stocks or funds can work, but it is a difficult trick to pull off, says Alwyn Owens at Dubai Financial Advice, a wealth management firm.
"You need plenty of nerve because it's never easy buying what nobody else wants and you need patience to stick to your guns and wait for your choice to come back into favour."
Perhaps the biggest challenge is psychological. If everybody loves a winner; it takes a different kind of investor to love a loser.