First what is contrarian investing? Contrarian investing is an investing approach that often runs counter to conventional wisdom. To do well you must adopt a strategy that is different from that of the mainstream. You cannot just get into the market, do what everyone else is doing and expect to make a lot of money. To do better than average you must do something different than that of the average investor.
Legendary investor and contrarian Warren Buffett says Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You cant buy what is popular and do well. Many of the most successful investors on Wall Street such as Warren Buffett, Marc Faber, Jim Rogers, and John Templeton are contrarian investors.
Contrarians look for crowd behavior among investors that lead to exploitable mispricing of equities. Crowd behavior in the market leads to mispricing of equities both on the upside and the down side. Widespread pessimism can lead the market to understate a companys real value and widespread optimism results in excessive prices and bubbles. The contrarian investing approach seek to take advantage of mispriced assets caused by the over optimism and over pessimism.
We humans are prone to stumble into metal pitfalls and according to legendary Ben Graham, the father of value investing; we are our own worst enemy in investing.
As investors we are over confident and we far too often make decisions based on our emotions rather than facts. The result of our psychological pitfalls can be found in the Dalbar study which measures investors returns compared to index benchmarks such as the S&P500. Over a 20 year period between 1990 and 2010, the S&P500 returned 8.37% annually but the return of the average investor and fund manager was a mere 3.17%.
Why such a poor performance for the average investor? There are many explanations and they all link back to our behavioral biases and mental pitfalls. We all have biases and blind spots but it is easier to discover them among other people then ourselves. To illustrate this point a survey at an American University was taken with participants being asked a how likely the average person was to make a particular mental mistake and how likely them themselves were to make the exact same mistake. The overwhelming result was that the participants thought the average person was more likely to make the mistakes then them themselves.
Another group of students were asked three questions in a survey:
1 Are you an above average drive?
2 Are you an above average student?
3 Are you above average at making love?
How would you answer these questions? If you are like the majority of the respondents you would have answered yes to all three questions. Over optimism and a self-serving bias seems to be embedded in the human mind. It may feel good to be confident but it often clouds our judgment.
It is far better to be skeptical when you are investing and adopt a contrarian mindset. Dont rely on other peoples opinions and dont let other people do your thinking. You are much better off by coming to your own conclusions even though you may be wrong from time to time.
Do your own research...
It is easy to find an investment that looks attractive at first glance. Once we have an investment we like it is not difficult to find conforming evidence to our initial judgment. Our mind is programmed to look for evidence supporting our original hypothesis. We have a behavioral deficit and a self-serving tendency of turning any information into supporting facts. Here are a few common examples
1 All news is good news. If it is bad news it can always be better.
2 The investment we picked is cheap (even if we have to make up new valuation methods.)
3 This time is different. Dont let some pesky facts get in the way of a good story.
We are far more likely to seek out information that confirms our views. We choose what we read and what we watch on television. We also choose our friends and we are more likely to get along with people that share our views. Most people are not confrontational by nature and it makes us more comfortable to be around people that agree with us. And even if our friend does not agree with us they may just go along with our conclusion rather than to be confrontational. So to find unbiased views we must talk to people with different opinions. Warren Buffett appropriately said Never ask a barber if you need a haircut.
Karl Popper, the great philosopher of science, developed a better method for finding unbiased facts and testing hypothesis. He used a contrary method and argued that the only way to test your hypothesis is to try to disprove it. Instead of looking for confirming information you should try to seek out information that disproves your evidence. If we finally come across an investment that we cannot disprove we may really be on to something.
As shown above we are subject to many behavioral pitfalls and it is easy to get caught up in counterproductive behavior. When we are asked in the cold light of day how we will behave in the future, we turn out to be bad at imagining how we will actually act in the heat of the moment.
To reduce the risk of falling prey to our emotional behavior we can prepare by pre-commit to a strategy. That means that we need to do our investment research when we are in a rational state of mind when there is little happening in the market. By pre-committing to a strategy we are less likely to fall prey to our own emotional behavior and we are more likely to follow through on our plan when the market is irrational.
It may be difficult to keep a clear head during a physiologically challenging event like a sharp market selloff but that is why we commit to our plan of action beforehand. Warren Buffett provides a good example of his strategy We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
By strictly following our plan we can remove a lot of the emotions and invest with a cold and rational mind. Using this strategy we can decide at what price to buy and sell beforehand and avoid suffering from mental pitfalls such as loss aversion and over optimism.