Follow-The-Leader Theory Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Follow-the-leader theory is an investment strategy that calls for investing money in the areas where already successful investors are putting it. It is essentially a form of momentum investment strategy, and reflects economist John Maynard Keynes’s comparison of the stock market to a beauty contest: Just as the most beautiful woman on the dais only wins if she’s voted for, the strongest stock only rises in value if people buy it. Objective strengths are not sufficient, without the subjective perception of them.

Though there is some intuitive sense to the theory, it also swims against the current of the stream of popular consciousness, which says that in the stock market, one should buy low and sell high. Momentum investment strategy in general calls for buying high and selling higher, and follow-the-leader theory generally adheres to that in practice, even if it does not prescribe it in so many words.

The strict form of momentum investment strategy invests in securities that have had high returns in the last quarter (or year, depending on the investor) while selling those with low returns in the same period. The risk is obvious—what goes up can rarely keep going up forever—but advocates point out that using this strategy can lead to benefiting from the poor judgment of other investors in the market. It was originally principally advocated by Chicago fund manager Richard Driehaus—one of Barron’s 25 most influential people of the 20th century in the mutual fund industry—and is similar to the positive feedback investing that super-investor George Soros used in the 1960s and 1970s.

To the extent that investing involves chance, that it is like and feels similar to gambling, momentum investment strategy ascribes value to the hot hand. When it is good, it will stay good; when it is bad, it will get worse. That this is significantly true a significant percentage of the time is the underlying predictive model of the strategy, and if your portfolio is diversified, it need not be true all of the time—no investment strategist would suggest all your eggs go in one basket, no matter the quality of the basket.

While “momentum investing” puts the emphasis on the movement of a stock’s price, and the perceived tendency of that movement to continue, follow-the-leader theory shifts the emphasis to those early adopters who can afford to take the initial risks (or take them anyway), the trailblazers making the initial push the momentum develops from. In a sense, what follow-the-leader theory does is codify and prescribe a natural human tendency to assume that takers of action know what they are doing. If someone in a long, slow-moving line at the grocery store gets out of the line and moves to another one, someone else will often follow him even if the reason for the move is not apparent.

The mutual fund newsletter The No-Load Fund Investor has been putting this theory into practice since 1976, in the form of its Persistency of Performance system, which buys the top-performing diversified stock fund of the previous year, with some modifications. While the average diversified fund has a 14 percent annual return, NLFI’s POP has a 21.5% percent return, a more than 50 percent increase. Others take that approach and apply it to stock sectors instead of specific stocks or funds, creating a portfolio of stocks from whichever sectors performed the best in the previous year.

There are obvious potential pitfalls. Although recent performance is often an indicator of future health, there is always an element of volatility in the market. The combination of momentum investing with the dotcom bubble would have led to enormous returns … for a while. Depending on just what was purchased and when, the dotcom portfolio could be pretty meager today, and a Dutch tulip portfolio would have seen tremendous gains for a brief period before crashing back down to near-worthlessness.

Bibliography:

Narasimhan Jegadeesh and Sheridan Titman, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” Journal of Finance (n.48, 1993);
Jack D. Schwager, The New Market Wizards: Conversations With America’s Top Traders (Wiley and Sons, 1992);
Garth Rustand, Investor Protection Workbook: Investors-Aid Guide to Protecting Investment Returns (IA Investors-Aid Inc, 2007);
George Soros, The Alchemy of Finance (Simon and Schuster, 1987);
Peter J. Tanous, Investment Gurus (New York Institute of Finance, 1997).

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