When you look at what average investors hold, you generally find a collection of securities concentrated within an asset class (perhaps all stocks), within a sector (such as energy, financial services or materials) or tied to a particular category (small-cap, mid-cap or large cap).

What is interesting is how the collection was purchased. In many cases, selections are random, with little thought given to concentration risks. Or, more likely, inves-tors have made choices without even realizing they have a concentration issue.

Fewer inves-tors still will understand the poor risk/return metrics associated with concentrated positions, although, occasionally, those strategies can produce decent short-term returns if the investor guesses right.

The problem is that no one is always right. And the high volatility typically associated with positive returns often results in a less favourable trade-off from a risk perspective, which is to say, a poor risk-adjusted return.

Dig a little deeper and it comes as no surprise that individual inves-tors are usually holding some version of the “pick of the day” approach. Individual stocks are bought and sold based on the view of others. When the suggestion comes from a broker, it might be a “buy,” “sell” or “hold” comment from analysts on television, or an interview in the financial press. In the end, a typical inves-tor’s basket looks much like every other investor’s basket, suggesting that stock prices have as much to do with peer pressure as they do with fundamentals.

Enter into this debate the madness of crowds. When enough investors buy a limited number of shares at the same time, the fundamentals supporting the stock’s price take a back seat to momentum. Irrational exuberance takes hold and prices climb for a short period, often beyond any level that can be justified by a company’s financial data. And we have a winner that again supports the “pick of the day” psychology until, ultimately, reversion to the mean comes into play.

It is a story that plays out over and over again — as with tech stocks in the late 1990s, real estate over the past five years, financial services companies in the past year and, now, perhaps, energy and commodity stocks. All will have the same results: peaking, then ultimately reverting to the mean.

Those of us who are in the investment business know this all too well. Just look at new products being offered in the market. To generate sales, companies manufacture what people have already shown interest in buying. No wonder, then, that we are seeing new commodity funds, natural resources funds and, more recently, funds investing in alternative energy.

This is not just a behavioural trait associated with making decisions to buy and sell securities. This is a trait ingrained in the way we live, a point made in a study au-thored by Matthew J. Salganik and Peter Sheridan Dodds of Columbia University and Duncan J. Watts of the Santa Fe Institute.

Salganik, Dodds and Watts had set out to gauge the impact of peer pressure. But rather than using investments, they did it with music. In this case, 14,000 participants were recruited and offered a random playlist of 48 songs that they could download.

The authors divided the participants into nine groups. The first group was provided with the random playlist and nothing else. Members of the remaining eight — call them “peer groups” — were provided with the same random playlist but were also given information as to the number of times a particular song had been downloaded by other members in their group.

What’s interesting is that members of each peer group saw only the results of other members within their own group. The result was that the study’s authors created nine independent worlds with the same playlist: one world that did not know what anyone else was doing and eight worlds that had knowledge of what others in their group were doing.

The peer groups were influenced not only by a song itself, but also by the popularity of the song among the other members of their group. The first result was interesting, although not surprising — at least, for those of us who, through many years of experience, have come to understand investor behaviour. The gap between the least popular songs and the most popular songs was much wider within the eight peer groups than it was in the one group that could not see what the other members of the group were doing.

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Another result was that the most popular and least popular songs within the eight peer groups varied. In other words, one peer group’s list of the top 10 songs was different from another group’s top 10 list. What the study tells us is that the gap between winners and losers remained consistent, but the actual winners and losers were random. Probably, it depended on how each group was influenced.

The results have interesting applications in the financial markets. We justify to ourselves why a stock or mutual fund was bought or sold. But, in reality, much of what we do is influenced by other inves-tors. This means that the price of a stock or performance numbers of a fund have as much to do with momentum as they do with real-world fundamentals.

Unfortunately, momentum usually means that individual investors buy and sell at exactly the wrong time.

Buying a mutual fund, a hot stock or a sector because of the recent performance numbers is like riding the cars of a freight train rather than driving the locomotive. The analogy to the locomotive is where the portfolio comes in.

The idea that the whole is worth more than the sum of the parts is what long-term investment management is about. We have to educate our clients that investing based on the views of others — rather than on a balanced view of how investments fit within individual portfolios — often includes unappreciated risks. If we can’t do that, our clients and our practice will end up with a basket of securities designed to follow trends.

More often than not, this approach ends badly.

And the band plays on. IE