The joy of contrarian investing

Herd

The irresistible urge to do what everyone else is doing

Self-reliance and independent thinking are tested in a crowd. Philip Fisher wrote: “A basic ingredient of outstanding common stock management is the ability neither to accept blindly whatever may be the dominant opinion in the financial community at the moment nor to reject the prevailing view just to be contrary for the sake of being contrary. Rather, it is to have more knowledge and to apply better judgment, in thorough evaluation of specific situations, and the moral courage to act ‘in opposition to the crowd’ when your judgement tells you are right.” (Fisher, Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p277.  

Who was Fisher? On November 15, 2013, Warren Buffett met with University of Maryland MBA Students. In notes taken by Professor David Kass, Buffett acknowledged that along with Ben Graham, Fisher was one of the greatest influences on his approach to investing, particularly as to how he viewed companies.

Fisher points to the “… inherently deceptive nature of the stock market. Doing what everybody else is doing at the moment, and therefore what you have an almost irresistible urge to do, is often the wrong thing to do at all.” (Fisher, 1958,1996) p32.

Our capacity for independent thought

Humans are deeply affected by the views of others. The issue comes up in many contexts. At the most extreme is the madness of crowds and mobs. Such madness is a real pathological human trait. Herd and lemming-like behavior are also fairly extreme.

More subtle are peer and career pressures. More subtle again and still very powerful is group thinking (Groupthink).

And then there are the forces that cause us to do what others are doing because we believe that what everyone else is doing must be right. This has been called ‘social proofing’.

In his 1906 book, The Nature of Capital and Income, Irving Fisher wrote: “Were it true that each individual speculator made up his mind independently of every other as to the future course of events, the errors of some would probably be offset by those of others. But, as a matter of fact, the mistakes of the common herd are usually in the same direction. Like sheep, they all follow a single leader.” (Fox, The Myth of the Rational Market, A History of Risk, Reward, and Delusion on Wall Street. 2009) p13.

Some have argued that, contrary to Irving Fisher’s view, the stock market benefits from the Wisdom of Crowds. This is a fallacy as I explain here.

Shiller points out that: “the popular notion that the level of market prices is the outcome of a sort of vote by all investors about the true value of the market is just plain wrong. Hardly anyone is really voting. Instead people are rationally choosing not to, as they see it, waste their time and effort in exercising their judgment about the market, and thus choosing not to exert any independent impact on the market.” (Shiller, 2005 Second Edition)p.160.

Deferring to the market

Some argue that prices in the stock market are ‘discovered’ by smart money and that any anomalies between ‘prices’ and ‘value’ will be arbitraged away. This is the so called efficient market hypothesis (EMH). The reality is that the stock market is messy and inefficient. I explain here.

 Warren Buffett offered his view of the EMH, writing in his 1988 Berkshire Hathaway Chairman’s Letter: “This doctrine [the efficient market hypothesis – here EMT for Efficient Market Theory] became highly fashionable – indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but also by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.”

Investors should keep in mind Warren Buffett’s words in the 2008 Berkshire Hathaway annual report: “Price is what you pay. Value is what you get.”

Readers will know I hate the expression ‘market value’. The market does not determine value. The expression should be ‘market price’.

We accept the opinions of analysts even if they plainly contradict matter-of-fact judgment

Coming up with a reasonable assessment of the value of a stock takes some work. Even with the assistance of an analyst’s report, some serious thought must be given to the question. In the Motherlode, Chapter 40. Finding and studying companies to invest in, there are several Sections on the strengths and weaknesses of analysts’ reports and how to get the most out of them.

It is a mistake to simply accept the analyst’s opinion at face value. Remember, analysts are also subject to groupthink and consensus views. It takes a brave analysts to hold unconventional opinions.

As John Maynard Keynes put it succinctly in The General Theory: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes, 1936,2007)p.158.

Philip Fisher warns investors not “to accept blindly whatever may be the dominant opinion in the financial community at the moment.” And yet, investors often accept these opinions without a moment’s thought.

Robert Shiller refers to experiments. He writes: “The experiments demonstrate that people are ready to believe the majority view or to believe authorities even when they plainly contradict matter-of-fact judgment. And their behavior is in fact largely rational and intelligent. Most people have had many prior experiences of making errors when they contradicted the judgments of a larger group or of an authority figure, and they have learned from these experiences.”

It is to be noted that Shiller is here referring to reliance on views considered to be authoritative or having expertise. This would be in contrast to reliance on an authority figure, i.e. a person in authority.

Shiller concludes: “it is not at all surprising that many people are accepting of the perceived authority of others on such matters as stock market valuations.” (Shiller, 2005 Second Edition)p.159.

Do your homework

The solution to all this is to develop a set of investment policies that encourage you to do your homework and think independently. I offer a set in a post here.

Bottom line

As Jesse Livermore put it in 1923, talking about the average investor: “He will risk half his fortune in the stock market with less reflection than he devoted to the selection of a medium-price automobile.” (Lefevre, 1923,1993)p.121.

Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

To read further on the use of analysts’ reports take a look at Chapter 40. Finding and studying companies to invest in

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

To access more blog posts check out the scatter alphabetic index (Tags) on the right above that goes from ‘accounting goodwill’ to ‘wisdom of crowds’.

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