Contrarian investing: How most investors are wrong most of time
On the 12th of June in our piece “The 35% Nikkei 225 round-trip: There and back again“, we here NipponMarketBlog reflected on the recent 20% plunge in the Japanese equity market, and suggested that this might be a good time to go long again. If nothing else then just from a simple contrarian viewpoint.
At that time in June when we made our suggestion, concerns about a possible earlier-than-anticipated ‘tapering’ of the US Federal Reserve’s quantitative easing program was widespread, and uncertainty and fear was clearly the dominant psychological under-currents in the market. At least, that was the general feeling at the time, and we have commented on why things may not be that simple in our piece “Investing, Causality and Human Nature“.
Slightly tongue-in-cheek, we also mused that a short term contrarian indicator (and thus a signal to buy) might be that Goldman Sachs’ Japan strategist Kathy Matsui was again beginning to sound decidedly more cautious about the market – no doubt as a result of the steep losses.
The Nikkei 225 has moved up almost 15% since then, and so our hunch that the market was set to go higher paid off nicely. This is a good example of contrarian investing, i.e. taking the position that is opposite from what the consensus seems to be.
The reason we have been highlighting Kathy Matsui’s comments over the past few months is not that we think she is incompetent. In fact, she is a very thoughtful and sensible lady, and having met her several times we can also say that she is a thoroughly pleasant individual.
However, Matsui and people like her are so submerged in the maelstrom of investor and investment banking opinions and sentiment, that she (and others like her) have a tendency to become a sort of barometer for market sentiment. In other words, if these individuals are bullish then there is a very good chance that most other investors in the market are also bullish. If they are bearish, there is a very good chance that most other investors are also bearish. This is especially true since this often becomes a self-reinforcing effect, where investors become more and more bullish the more they interact with other bullish investors. This is where contrarian thinking can be applied.
Contrarian investing is a difficult thing to get right, for the simple reason that it involves taking the diametrically opposite view from the market, and hence the majority of other investors.This must of course not be done blindly. Doing the opposite of what everyone else is doing is not in itself a way to generate returns. One has to have a good grip on the market at the time, both in term of equity valuations and the underlying fundamentals of the companies listed on the market. But over the short term, reading investor sentiment and exploiting excessively bullish or bearish periods, in order to act as a contrarian can yield very good returns.
The point about the difficulty in doing the opposite of what other people are doing relates to human nature and makes itself felt, not just in equity markets, but more broadly in every aspect of human behavior. Taking the exact opposite position from the rest of the individuals around us is inherently risky, and runs counter to some of our deepest instincts.
Imagine for example a group of our ancestors two million years ago moving across the African savannah. An individual at the front of the group spots a lion coming towards him, and immediately begins to run away. The best chance of survival for the other group members is to run in the same direction as him, even if they do not know what they are running from. If one of the group members (let’s call him The Contrarian) observes this situation, and then begins to run in the exact opposite direction from the group, he will likely end up as lunch for the lion.
This is a very simplistic example, but it demonstrates how following the herd is very sensible in most human endeavours. ‘Herding behavior’ is instinctive and deeply ingrained in all of us humans, and it has served us well as a survival technique for millions of years.
However, returning to modern day equity markets, things are obviously very different, but crucially human nature remains the same. Most investors follow the herd. The more the market goes up, the more bullish they become. The more the market goes down, the more bearish they become. One might initially think that if one’s expectations about the market are perfectly aligned with that of the majority (or perhaps even all) of the other investors in the market, then one would be guaranteed to make money.
In fact, the exact opposite is true, and if an investor ever finds his view precisely aligned with that of everyone else, then he should be very concerned. NipponMarketBlog has always held this view:
The market will almost always do what surprises the largest number of investors.
The dynamic behind it is straight forward. Very simply speaking, if 50% of investors think the market should be going up and 50% think the market should be going down, then chances are the market will bounce around in a narrow trading range driven by short term news flow. If overall sentiment improves (possibly driven by positive data or news flow), then more investors will become positive on the market, and the balance will shift to say 60%/40%. If yet more reasons appear to become positive on the market then the balance may shift to 70%/30% and then to 80%/20% and so on.
Every time sentiment shifts and becomes more positive, even more investors buy the market and the market goes up a little more. The crucial point here is that as this process goes on, the number of marginal buyers becomes smaller and smaller (causing the market to go up by less and less every time, and thereby causing the average gain for the average investor to become very small), until finally almost everyone agrees that the market is a ‘BUY’ and so at this point they will almost all have bought the market.
But of course, if virtually everyone has already bought the market, then on the margin that leaves virtually only sellers. In other words, there is now only a tiny number of marginal buyers left to support a continued upward move, but at the same time an enormous amount of potential sellers has built up. So if suddenly the underlying narrative of the market changes and/or some new information arrives that contradicts the initial bullish stance, then instantly the market dynamic changes since sellers now vastly outnumber buyers and the market crashes as everyone heads for the exit all at the same time.
Notice how from an outside observer’s point of view, most investors were ‘right’ most of the time, in that they were bullish when everyone else was bullish, and they became bearish as everyone else was becoming bearish, but for that exact reason they all still ended up losing money. They all agreed on the same thing, but the more they agreed, the more the negative outcome for all of them became inevitable.
This fight against the deeply ingrained instinct to go along with the herd is what contrarian investing is all about. Staying in control of one’s emotions, and being able to objectively observe other investors and assess overall market sentiment is crucial to successful contrarian investing.
The spectacular performance of Japanese equities since late 2012, the 20% correction from mid June, and most recently the almost 15% bounce from the bottom should all be seen in the context of this market dynamic.
When, in our title for this piece, we pointed out that most investor are wrong most of the time, it is not because they are unintelligent, or because they are irrational (although that does tend to happen from time to time), or because they do not have adequate access to information on which to base their investment decisions. It is almost always because they are unable to keep one of their deepest instincts in check, and remain detached from the overall market (herd) sentiment.
This dynamic clearly applies both to whole markets and to individual stocks. It is often obvious that individual stocks are moving higher simply on sentiment, which in turn is fueled by the very fact that the stock is moving higher. This is when stocks can move exponentially, and this is where contrarian thinking becomes important, because on the one hand there is scope for riding the wave and making money, but on the other hand – how does one know when to exit?
Momentum investors have no other guide to their buy/sell decisions than the stock’s own performance. By contrast, investors who are able to read market sentiment and also behave in a contrarian fashion, and who have in place a disciplined valuation based investment process, will be much better able to resist the ‘herding effect’ that we have described above.
This is because they will have a clear sense of what an appropriate market level should be, and this in turn will allow them to step back from the market when things become overly excited, and subsequently pick a more attractive entry point once the market has corrected.