It's hard to avoid getting caught up in the latest investing fad. But if you knew that buying what everyone else wants is likely to cost you a huge amount in annual returns, you might think twice before jumping onto the bandwagon at the last minute.
Following the crowd off the cliff
In any market, you can always find some sectors that seem to attract all of investors' attention. Whether it's because of hot performance, strong fundamentals, or simply hype, new investors will often steadily flow into the same positions that other investors have made before them.
At the same time, money to fund those positions has to come from somewhere, and so you'll also always find out-of-favor areas of the stock market. Dour financial prospects as well as ample liquidity to sell holdings and generate cash to buy more desirable stocks help to push those investments down hard.
But according to a recent study from Morningstar, that herd-following mentality is exactly the worst thing you could do. By looking at mutual fund performance results in different market sectors over the past 10 years, the fund research company found that if you bought funds in the sectors that had seen the greatest amount of redemptions from other investors selling out, you could have generated a much greater return than if you'd bought funds in sectors that were popular and attracting inflows of money overall. In fact, the results were striking -- unloved funds rose an average of 3.7% annually, while the most popular fund categories lost 1.2% per year.
Dumping the hot stocks
So if you think that rule of thumb makes sense, what should you be doing right now to prepare for 2011? Morningstar reports that the hottest areas of the market included emerging-market stocks, commodities, and large-cap international stocks generally. Meanwhile, large-cap U.S. growth and value funds have seen huge outflows even in the face of a strong rally since September.
On the selling side, that means taking a close look at these stocks:
- Baidu (Nasdaq: BIDU ) shares have risen 10 times in just the past two years, and despite its impressive growth in a market with seemingly infinite potential, the stock is priced for perfection.
- Commodities stocks BHP Billiton (NYSE: BHP ) and Vale (NYSE: VALE ) have benefited from high prices and strong demand from China and elsewhere. Yet while some expect prices to continue higher, we're already at all-time highs in gold and multiyear highs in most of the other precious metals.
As for foreign stocks, it's clear that not every international stock is on top of the world right now. You can take your pick of knocked-down European stocks, some of which may be really great values -- and others of which could be classic value traps if the sovereign debt crisis doesn't resolve itself soon.
Grabbing a cold one
But in general, where you should look to add to your investments is in stocks close to home. U.S. stocks aren't necessarily all that flashy right now, but some of the valuations we're seeing are amazing. Clorox (NYSE: CLX ) , McDonald's (NYSE: MCD ) , and Wal-Mart (NYSE: WMT ) are all selling near the bottom of their valuation range over the past five years, yet they each have stable and steady results and pay decent dividends.
Many investors feel that putting their money in the U.S. requires tacit approval of government policies and the overall economic climate. But in the global economy, many U.S. companies have big edges over their competition -- so you're still getting help from overseas strength. And just as importantly, some companies will inevitably benefit from economic policy even if it's bad on the whole. Mortgage REITs like Hatteras Financial (NYSE: HTS ) are on top of the world because of ridiculously large interest rate spreads and the unofficial propping up of agencies Fannie Mae and Freddie Mac. The longer extraordinary measures last, the longer they'll keep paying huge dividends to patient shareholders.
Beat the crowd
It doesn't take much to beat herds of scared investors. All you have to do is take a different angle toward your investing. By staying aware of possibilities, you can get a huge edge on your competition -- one that will pay off in the long run.
The crowd is headed for painful times after they retire. You don't want to join that herd. Click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.