Michael Mauboussin Contrarian Investing: The Psychology of Going Against the Crowd

Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns   (Harvard Business School Press, 2001).

Excerpts from a presentation given to the Greenwich Roundtable, February 24, 2005

Good morning. In addressing this morning’s topic, I’d like to make three points:

• First, I will try to define what contrarian investing means; at least I’ll try to offer one way to think about it. This part will define one of the hardest parts of investing and one of the most common errors: a failure to distinguish between fundamentals and expectations.

• Second, I’ll spend a few moments on market efficiency, a terribly important issue that most active managers don’t seem to think about much. This section will propose some ideas on how and why markets are efficient, which will lead us to a discussion of how and why markets periodically become inefficient.

• Finally, I’d like to touch on why it’s so hard to be a contrarian investor. I will argue that there are two types of constraints: institutional and psychological. Clearing either one of these hurdles is difficult for an investor; clearing both is nearly impossible.

Michael Mauboussin What the Game is About

When I consult my dictionary, a contrarian is “one who takes a contrary view” with contrary defined as “being not in conformity with what is usual or expected.” Basically, a contrarian runs against the crowd.

Let me start with an obvious statement: the simple act of being a contrarian will make no one rich. In fact, conforming generally makes the most strategic sense. If you’re in a movie theatre that catches on fire, you’d be best served to run out of the theatre in contrast to the contrarian tack to run into the theatre.

This point may seem trivial, but it has very deep-seated psychological roots. Many survival strategies in the animal kingdom rely on cooperation. One simple example is flocking—schools of fish, or flocks of sparrows, act in unison to minimize the threat of a predator.

If being different—not conforming—is not the sole goal, what should the aspiring contrarian focus on? Here I turn to a common sense distinction that I would argue is the single most common error in the investment business: failure to distinguish between the fundamentals of the situation (for example, the fundamentals of a company in the case of stocks) and the expectations reflected in the asset price.

Horse racing provides a good metaphor for this distinction. There are two issues: how well the horse will likely run—to figure out the fundamentals you’d look at the horse’s record, the stable it came from, the jockey, the track conditions, etc.—and the expectations, which show up as the odds posted on the board.

Evidence shows that horse racing is a pretty efficient market. To quote a study by Professor Ray Sauer on the topic, “prices set in these markets, to a first approximation, are efficient forecasts of outcomes.”

A contrarian investor focuses not only on the general sentiment, but more importantly on how that sentiment can lead to disconnects between fundamentals and expectations.

To continue with the horseracing theme, I’d like to read a quotation from Steven Crist, now Chairman of the Daily Racing Form and for many years the The New York Times Company (NYSE:NYT ) reporter covering horse racing. Crist contributed a chapter to a book called Bet with the Best. Crist’s 13-page chapter “Crist on Value” is fabulous reading and stacks right up against Warren Buffett and Ben Graham.

Here’s Crist’s comment, and please mentally strike out “horse” and insert “stock”: 2

The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think that they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price. (Emphasis added.)

The successful hedge fund manager, Michael Steinhardt. shared a very similar view in his 2001 autobiography: 3

I defined variant perception as holding a well-founded view that was meaningfully different than the market consensus. Understanding market expectation was at least as important as, and often different from, the fundamental knowledge. (Emphasis added.)

Now ask yourself, very honestly, how clearly do you distinguish between fundamentals and expectations? If you’re like most people, not very clearly. I quote a psychologist Robert Zajonc, who sums it up pretty well: 4

We sometimes delude ourselves that we proceed in a rational manner and weigh all of the pros and cons of various alternatives. But this is seldom the actual case. Quite often “I decided in favor of X” is no more than “I liked X”. We buy the cars we “like,” choose the jobs and houses we find “attractive,” and then justify these choices by various reasons.

Moreover, what we like is heavily influenced by what other people like. Successful contrarian investing isn’t about going against the grain per se, it’s about exploiting expectations gaps. If this assertion is true, it leads to an obvious question: how do these expectations gaps arise? Or, more basically, how and why are markets inefficient?

Michael Mauboussin The Rules of the Game

In his excellent book, Inefficient Markets. Harvard professor Andrei Shleifer summarizes the three arguments that underpin the efficient market hypothesis (EMH): 5

1. Investors are rational, and value securities rationally. This is the basis for so-called general equilibrium models.

2. Investors are not rational, but their errors are independent, and hence cancel out, leaving us with an “efficient solution.” And,

3. The no-arbitrage assumption—even if some investors are irrational, rational arbitrageurs swoop in and eliminate those inefficiencies.

The burgeoning behavioral finance field takes aim at the efficient market hypothesis, focusing its efforts on undermining number one, the rational agent model, and number three, the no-arbitrage assumption. By and large, though, behavioral finance dismisses the second alternative out-of-hand. We’ll come back to that in a moment.

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