Pitfalls and Misconceptions of Contrarian Investing

by: Isam Laroui

The old quip "just because you're paranoid doesn't mean they're not out to get you", to which I'll add "and even less that they won't get you", nicely illustrates a very common misconception when it comes to contrarian investing. In its simplified version, the misconception goes something like this: if a majority of people think something bad is going to happen, then it won't happen.

On the face of it, this sounds ludicrous, doesn't it? And yet that is essentially what many market strategists have been saying for the past month in one form or another. They point out that an overwhelming majority of economists, various pundits, and now even our President-elect have been warning us that 2009 will be a disastrous year with rapidly rising unemployment, rapidly falling economic activity and more generally alarming statistics all around. This, the would-be contrarians contend, is proof enough that all the bad news have been discounted and that investors should position themselves, against the majority, for a better-than-expected 2009.

The problem with this line of reasoning is that its underlying assumption, essentially the folk version of Contrarian Theory, that most people are wrong most of the time is just plain wrong. Martin Pring, in his excellent Investment Psychology Explained, reminds us that the Theory of Contrary Opinion says that "the crowd (i.e. the majority of investors or traders) is actually correct most of the time; it is at turning points that they get things wrong".

As any behavioral economist will tell you, accurately gauging the majority opinion is extremely difficult to start with. And even if one could correctly (and not only anecdotally) assess what the majority opinion actually was,

this knowledge [would] still result in frustration, because the crowd frequently moves to an extreme well ahead of an important market turning point.

As John Schultz wrote in a 1997 Barron's article:

The guiding light of investment contrarianism is not that the majority view - the conventional, or received wisdom - is always wrong. Rather, it's that majority opinion tends to solidify into a dogma while its basic premises begin to lose their original validity and so become progressively more mispriced in the marketplace.

In other words and to paraphrase Keynes, the crowd can stay irrational much longer than a trader can stay solvent.

The fact that so many people are making the contrarian argument that 2009 will be better than expected compounded with the fact that many things that are widely expected to go right could go very wrong, the most important of which, in my opinion, being the stimulus package (remember how it was supposed to be signed on Inauguration Day, then before February and now before March) lead me to be very wary of the contrarian bullish case. I don't doubt that the market could mount a few technical counter-trend rallies throughout the year but the idea of a sustained bullish move seems a little extravagant.

After being so wrong for so long, the majority opinion may unfortunately get this one right: 2009 may indeed be a very bad year.