The Dangers of Following the Herd

How Jim O'Shaughnessy survives and adapts to markets constantly in flux

Real Vision’s Ed Harrison hosted longtime investment professional and fintwit’s reigning GIF king, Jim O’Shaughnessy, chairman and co-CIO of O’Shaughnessy Asset Management, to understand how Jim has been able to survive and adapt to markets constantly in flux. He posits that the ever-changing nature and difference of opinions among market participants drive its efficiency. It’s when opinions converge, and correlations go to one that things start to get hairy.

Citing the market’s reaction to coronavirus as the perfect example of this dynamic he adds the caveat that this is a feature of equities and not a bug. This risk of economic downturn and the potential for shocks from known unknowns is the very reason why stocks carry a risk premium, allowing long-term holders to outperform less risky assets like CDs and bonds over time.

Ironically almost everyone is able to recognize these features in other people, but is terrible at recognizing it in themselves. We act against our own best interest and against our own views sometimes, especially when we are following the herd. Essentially, human nature and markets don’t mix. We suffer from group think, we make snap emotional decisions, and often even when we recognize these facts, we exempt ourselves from being capable of being tripped up by these pitfalls. That’s why he has created a quantitative model that allows him to be as emotional as he wants without affecting his investment decisions.

For most people this Jim recommends a simple system, just buy the index. If you aren’t sophisticated enough or if you don’t have enough time to learn, then the cost benefits of index funds are just too great to pass up, though he cautions investors on cap-weighted indexes because of the lack of focus on valuations.

Jim has taken this index fund philosophy to his own business with the twist that individual investors can choose to pull out anything they don’t want or add anything extra that they do want from a traditional index. This allows investors a little bit of emotion in their portfolio but keeps them mostly systematic.

In the end that is what his business is all about and why he sees value in financial advisors. Advisors have the ability to be agnostic about downturns as it isn’t their money. When things are going well this may make you feel like you are getting nothing for your advisor fees, but when the market turns down and you become emotional, it helps to have someone there to check you and keep you grounded.

Jim gives plenty of historical and personal examples to make his case throughout the interview, but they all boil down to a few things. If you reduce your emotional reactions, have someone to check you when you panic, and extend your time horizon, then you will be a happier and more successful investor.

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