Thinking Contrary to the Crowd: An Approach to Investing

by: Barry Ritholtz

Herb Greenberg has an interesting column this weekend on being a contrarian (If Your Friends Jumped Off A Bridge, Would You?). He says some nice things in it about your humble scribe (I have a quote in it). We spoke earlier this week, and that conversation got me thinking about being a contrarian, and the elements that go into this approach.

Consider the following aspects to thinking contrary to the crowd:

1) You cannot be a full time contrarian. Why? The crowd is actually right most of the time. Remember, they are what moves markets, why equities go up, why a pop song becomes a #1 hit. Indeed, the crowd is why indexing works.

2) This gets reflected in such cliches as "Don't fight the tape" and "The trend is your friend;" The crowd is neither right nor wrong, but instead is its own truth, a self fulfilling prophesy. This leads to some unexpected outcomes.

3) Beware extremes: The crowd will take markets much higher and much lower than they should go based on reasonable, logical common sense metrics.

4) There is safety in numbers. No one gets fired for groupthink. In every nature documentary that you have ever seen, it's the gazelle at the edge of the herd that the lions devour. The rest of the herd is safely huddled together. That's the anti-contrarian lesson (if you're a gazelle).

5) Whenever the crowd loves or hates something, it's worth noting. That's when contrarians are the ones who will make a giant score. Think short-sellers in Enron or Tyco, or the buyers of tech stocks in late 2002.

6) Where contrarians shine is when the crowd morphs into an angry mob. Once the bulls become convinced the market is invincible, their full throated cries will be readily apparent. So too, the bears, usually in the depths of a recession.

7) It is worthwhile to quantify consensus vs variant perception, rather than rely on gut feelings. A few years ago, I put together a guide to the Contrary Indicators of the 2000-03 Bear Market. It outlines both the anecdotal AND the measurable contrary signals (and 2003 was a great buying opportunity). Use both the anecdotal and quantitative approaches in concert.

8) The idea of Variant Perception is that when most investors know something, it is already built into the stock price. Therefore, going along with the crowd will not generate alpha or above market performance.

9) Consensus equals closet indexing. While I favor indexing for many investors, investing with the consensus can be more expensive. The cheaper way to achieve the end goal of consensus investing at a lower cost is to simply buy and hold index funds.

10) Forget forecasting: Most people do not even understand the present with any precision or accuracy. There's a reason for that: there are powerful interests with a vested stake in presenting the world in a certain way. Their spin on events serves their own narrow purpose, often to the detriment of the public. (Hence, my tendency to push back and be skeptical of what I am spoon-fed).

I include in this group of malevolent spinners politicans, Wall Street (especially bulge bracket firms), government data sources, big mutual funds, media, and industry spokesgroups. The mainstream media can be a source of both information and misinformation; the difficulty is knowing on whom and on what to rely. I try to highlight the better sources here on a regular basis.

Being a contrarian is a lonely but potentially profitable occupation. Just ask Doug Kass, Bill Fleckenstein, Dennis Gartman Jim Rogers or Mark Faber.

When time permits, I hope to expand this at some later date into a full Apprenticed Investor column . . .


If Your Friends Jumped Off A Bridge, Would You?
It's Important for Investors to Challenge the Herd
WSJ, January 13, 2007; Page B3
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