A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

participants. The phenomenon is another example of the
Ponzi scheme that I described in chapter 4, in connection
with the Internet bubble. Eventually one runs out of greater
fools.
Such herding is not limited to unsophisticated individual
investors. Mutual-fund managers have a tendency to follow
the same strategies and herd into the same stocks. Indeed, a
study by Harrison Hong, Jeffrey Kubik, and Jeremy Stein,
three leaders in the field of behavioral finance, determined that
mutual-fund managers were more likely to hold similar stocks
if other managers in the same city were holding similar
portfolios. Such results are consistent with an epidemic
model, in which investors quickly and irreversibly spread

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information about stocks by word of mouth. Such herding has
had devastating effects for the individual investor. While long-
run returns from the stock market have been generous, the
returns for the average investor have been significantly
poorer. This is because investors tended to buy equity
mutual funds just at the point when exuberance had led to
market peaks. During the twelve months ending in March of
2000, more new cash flow went into equity mutual funds
than during any preceding period. But while the market was
reaching a trough in the fall of 2002, individuals made
significant outflows from their equity investments. A study
by Dalbar Associates suggests that the average investor may
earn a rate of return well over 5 percentage points lower than
the average market return because of this timing penalty.
In addition, investors tend to put their money into the
kinds of mutual funds that have recently had good
performance. For example, the large inflows into equity
mutual funds in the first quarter of 2000 went entirely into
high-tech “growth” funds. So called “value” funds
experienced large fund outflows. Over the subsequent two
years, the growth funds declined sharply in value while the
value funds actually produced positive returns. This selection

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penalty exacerbates the timing penalty described above. One
of the most important lessons of behavioral finance is that
individual investors must avoid being carried away by herd
behavior.