Investing With The 'Wisdom Of Crowds'

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Includes: DVP, MOAT, SDOG
by: Nicholas Vardy, CFA

Investors are forever on the hunt for the "Holy Grail" of investing - a strategy that consistently outperforms the stock market through thick and thin.

Some investors swear by value investing. These folks believe that you make your money when you buy a stock rather than when you sell it. Consistent tortoise-like returns trump flash-in-the-pan double-digit percentage gains over time.

Other investors swear on the alluring prospects of "exponential growth." They count on the stellar returns of a well-timed - and lucky - bet on the "next Google" that will be responsible for the next generation of billionaires.

Traders are more technically oriented momentum players who surf the markets much like a surfer rides the waves of an ocean. They react more to the opportunities the market has to offer at the moment rather than following the strict, almost religious tenets of a particular investment philosophy.

Investment 'Hedgehogs' versus 'Foxes'

I envy those who have a single rigid philosophy - the "hedgehogs" of the investment world. After all, they have it easy. Ask them any question, and they always give the same answer, no matter what.

Hedgehogs are investors who know one thing - and they know it well. A hedgehog will tell you that the "holy grail" of investing is to "buy gold" (Peter Schiff)… or to "buy China" (Jim Rogers)…or to… "buy index funds" (John Bogle).

For hedgehogs, it is their way or the highway. Those who fail to see the light are just part of the ignorant "great unwashed." In short, hedgehogs are the ideologues of the investment world.

In contrast, when a "Fox" looks at the world, he sees it as complex and changing - a dynamic game of three-dimensional chess, a puzzle to be solved.

Believing that there are no easy answers to complex questions, foxes pray no more at the altar of Warren Buffett than they do at the feet of George Soros.

Although foxes are often wrong, studies have confirmed that foxes are wrong less often than hedgehogs who provide simple answers.

Enter 'The Wisdom of Crowds'

Like a real fox, I believe that every investment strategy has its day and that those days come and go. I also believe successful investing is more about incorporating diverse viewpoints at different times to eke out a relatively small edge rather than having the ability to give an answer to an investing question before you even ask it.

Here, I was inspired by the insights from the "wisdom of crowds" - which I first read about in James Surowiecki's book of the same title.

In his book, Surowiecki argues that the aggregation of particular insights results in decisions that are often better than those of any single expert.

The "Wisdom of Crowds" opens with the story of the eugenicist Sir Francis Galton's shock that the "dumb" crowd at a county fair in England accurately guessed the weight of a butchered ox the best. The average guess of the group was closer to the ox's true weight than any of the individual estimates.

The conclusion was as clear as it was surprising: the crowd was "wiser" than any individual in it.

This experiment has been repeated dozens of times in different contexts, with a group, say, guessing the number of jellybeans in a glass jar.

You also see the "wisdom of crowds" at work in the "Who Wants to be a Millionaire" game show. Expert "friends" on the show get the correct answer two-thirds of the time. However, the "dumb" audience gets the answer right 91% of the time.

There are some caveats.

For a crowd to be "wise," it has to meet three requirements, Surowiecki argues.

First, there should be a diversity of opinion. Each person should have his/her interpretation of the facts - even if it is considered completely outlandish.

Second, opinions should be independent, unswayed by the vagaries and pressures of a crowd around them.

Third, there should be decentralization of those who give their opinion. People should be able to develop and draw on their specialized area of knowledge.

The final step is aggregation, whereby a mechanism turns individual judgments into collective decisions.

Applying the Wisdom of Crowds to the World of Investing

It was based on this insight on the Wisdom of Crowds that I developed the Alpha Algorithm - a computerized approach to investing that collects and collates diverse, independent opinions from a range of (often contradictory) investment philosophies.

As remarkably diverse as investment philosophies are, it is equally remarkable how many of them converge on choosing the same stocks - whether these stocks are household names or unknown small-cap stocks.

With that, here are 2016's three top-performing investment strategies focused on the U.S. stock market among the 30+ - and growing - number of strategies I track on a daily basis for the Alpha Algorithm.

  1. ALPS Sector Dividend Dogs ETF (NYSEARCA:SDOG)

This strategy invests in each of the five highest-yielding stocks in each of the 11 sectors of the S&P 500. It is based on the belief that high-yielding equities tend to appreciate faster than lower-yielding stocks. In a yield-hungry world, this strategy is up 16.21% year to date and 10.41% annually over the past three years. It currently yields 3.26%.

  1. Deep Value ETF (NYSEARCA:DVP)

The Deep Value ETF tracks an index of 20 stocks chosen from the S&P 500. The index aims to find deeply undervalued stocks using fundamental screens, enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) and price/free cash flow. The selection process means it has a substantial mid-cap tilt and major sector biases. This strategy is up 15.42% year to date. It currently yields a whopping 4.32%.

  1. VanEck Vectors Morningstar Wide Moat ETF (NYSEARCA:MOAT)

This strategy tracks an equal-weighted index of 20 companies that Morningstar analysts believe have the highest fair value among companies with a sustainable competitive advantage or "moat." This strategy is up 14.49% year to date and 7.83% annually over the past three years. It pays a modest 1.81% dividend.

No single stock appears in all three of these top-performing strategies - although six stocks appear in two of the strategies.

Still, despite their widely differing approaches, each of them is outperforming the broader S&P 500's return of 4.17% year to date by at least three to one.

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