In my last post, I introduced my definition of the ideal investor temperament. I believe that it includes traits such as:
- Probabilistic thinking
- Your attitude toward mistakes
- How you measure success
- How you treat others
This list is by no means exhaustive or definitive, but I believe that it’s a good start. In this post, we continue our exploration of the investor temperament by considering what it means to be a contrarian and why all successful investors are contrarians.
Why put a question mark next to contrarianism? Because it’s probably the most misunderstood quality on my list. Many people believe that contrarianism simply means going against the crowd. Sometimes that’s the case. But as we’ll consider later on, simply going against the crowd on everything isn’t contrarianism.
Some believe that being a contrarian means being a value investor. But there are also many examples of growth investing also requiring a contrarian mindset. For example, consider the frequent and violent drawdowns experienced by Amazon; a company that many consider to be the ultimate growth company. Only a true contrarian could remain invested when faced with such volatility.
For a long time, index investors were also contrarians. They eschewed the prevailing wisdom of trying to beat the market. Indexing has now gone mainstream. Perhaps its recent popularity will affect its future performance?
One of the first people to formalise the notion of what it means to be a contrarian thinker was the American author and investor Humphrey B. Neill. Neill wrote an investment newsletter, Letters of Contrary Opinion, and several books, including The Art of Contrary Thinking. He was dubbed the “father of contrary opinion,” by Life magazine in a 1949 article.
Neill counted some of most famous money managers of the day as his readers, including Fidelity’s Ed Johnson II. Johnson admired Neill so much that he based one of the most successful mutual funds of all-time, Fidelity’s US $120.4 Billion Contrafund, on Neill’s investment approach.
A State of Mind
In his book The Art of Contrary Thinking, Neill describes what’s required to be a contrarian.
Inasmuch as very, very few people ever take the trouble to look at both sides of questions – indeed, ever take the trouble to think very much even on one side – it is obviously of great advantage to be among the tiny minority that does exercise its brain occasionally. This is not written in an effort to be funny. It is an actual fact that the majority of people acquire information and form opinions second hand – from something they read hurriedly or hear with half an ear.
Contrarianism isn’t a personality trait. Rather it’s a state of mind where the contrarian is open to a wider range of possibilities. This involves deliberately considering the opposite, or counter-argument. It also involves considering how the current opinion can be even more ‘right’ than most people expect. Neill describes it this way.
- Establish the extrapolation (e.g. the current stock-market trend is up, therefore it will continue up)
- Consider all conditions and qualifications that come to mind which conflict with, or nullify, the idea that trends will continue to run on as in the present (down if up, and vice versa)
- Think of motivations or circumstances that might activate trends to a greater degree than presently prevail (emphasis added)
Most people associate a contrarian viewpoint with steps 1 and 2, not step 3. Which is why they assume that contrarians are stubborn and closed-minded. This is ironic, since a true contrarian is attempting to actively consider possibilities, both good and bad, that the market doesn’t anticipate.
Considering the counterargument doesn’t necessarily mean adopting it. Sometimes being a contrarian requires an investor to be more bullish (bearish) than an already optimistic (pessimistic) market consensus.
I’ve seen the benefits of doing this first hand. One of my clients, a long/short equity hedge fund, constructs bear and bull market paper portfolios. The idea is similar to newspapers preparing two headlines and cover stories on an election night. Whatever happens, you’ve got a plan ready to go.
Creating and maintaining the two portfolios prompts this hedge fund to think deeply about how the stocks they cover will be impacted by economic and market events.
It also makes change easier to implement. The investment team have less of a struggle changing their minds because they were already open to more than one set of possibilities. In other words, they are less likely to hesitate when making decisions. They won’t feel “wrong” when making a change because they explicitly considered the possibility all along.
In this passage, Neill is also giving us a clue as to why contrarian thinking works: humans are lazy by nature. That’s another reason why curiosity is so important: it’s a natural defence against lazy thinking.
Choose Your Battles
A true contrarian understands that the market gets it right most of the time. There is a time and a place in which to be a contrarian. Neill explains.
The ‘crowd’ has always been found to be wrong when it counted most to be right. This is a bit quippish; a more sedate reply would be that the crowd is wrong at the terminals of trends, but right, on the average, during trends… One might suppose from this that a simple formula for acting in a contrary manner would make it easy to rake in the profits.
However, those traits of human nature have to be dealt with, and they are obstinate obstructionists indeed! Above all, what makes it practically impossible to beat the game is the trait of IMPATIENCE.
Neill is describing a power law relationship; more commonly known as the 80:20 rule. In other words, the market is right the majority of the time. But it’s the minority where the market is wrong that accounts for the bulk of the outcome.
The lesson: If you’re always following the herd, you’re wrong. And if you’re always swimming against the tide, you’re wrong.
As Neill reminds us, realising this fact doesn’t make being a contrarian any easier. Being a contrarian requires patience just as being patient often means being contrarian. The two are inextricably linked.
Why Every Good Investor is a Contrarian
Every good investor needs to be a contrarian. This is because markets are constantly discounting new information. Once again Neill provides us with a helpful explanation:
It is not that the many are wrong in their analyses, but that they may be proven wrong because of their influence. They may so affect operations and plans of business (and of the public) that their forecasts fail to prove out. If you are convinced that inflation is going to accelerate you will manage your inventories and bank loans differently from what you would if you had been led to expect a slump. Collective action, from united predictions, often pushes the pendulum too far in one direction – thus upsetting the “timing “and the momentum previously expected… So it is that economists may see their published predictions go wrong whereas if they had kept them secret the forecasts might well have worked out with extraordinary accuracy.
Neill is referring to economists in this quote but the principle also applies to investors. The actions of market participants virtually guarantee that consensus option will be wrong. Not all of the time, but certainly when it matters most. This is why every good investor has to be a contrarian.
If a Contrarian is Right in a Forrest…
Benjamin Graham is rightly considered one of the fathers of modern investing. As revered as Graham is, his advice sometimes seems to be selectively quoted. For example, Graham advised value investors to sell stocks (no matter how cheap) if there has been no significant improvement in the share price after 2-3 years. This advice rarely appears among the many Graham quotes in books and on the internet.
Graham understood that it’s not enough to be a contrarian. You only make money if the market eventually catches up with you. This is especially the case with value investing where the strategy predisposes investors to buying poor businesses in the hope that the market has over-exaggerated the problems that they face. If the problems don’t get solved and/or the market doesn’t notice, all you’re left with is a bad business. Doesn’t really matter how cheap it is. That’s why Graham put a common-sense term limit on his contrarian views. Like any investment decision, risk management should be an important part of the process.
In summary, contrarianism isn’t a personality trait, it’s a state of mind. It prompts investors to be open minded by considering a wider range of possible outcomes. This makes it easier for them to act when circumstances change. Contrarian thinking results in selective differences from the crowd on key issues or at pivotal moments. It anticipates what may happen and won’t always be correct, which is why common sense (i.e. setting a time limit) and risk management are essential. It also fundamentally linked with patience, the topic of my next post.
 Under the pen name the “Vermont Ruminator”
 As at 30th November 2018.