By: Dan Erdle

Overview

The purpose of this post is to explore the many benefits of thinking and behaving differently. I also wish to explore why human nature makes it so difficult for us as investors to go against the crowd. I hope to get across the point that it is unrealistic to expect that if you think and behave like other investors that your results will be anything but average. In order to have superior investing results an investor must develop the ability to engage in independent, objective analysis free from the pull of conventional wisdom or popular thinking. Successful investors will also develop an ability to maintain a portfolio influenced by a high degree of contrarianism.

Outcome Distribution

When thinking about this topic I have found it helpful to keep an important visual in mind. It comes from statistics and is called the “normal distribution.” It can be applied when thinking about outcomes in numerous areas of life, business, and investing. The normal distribution follows a bell shaped curve with most of the outcomes bunched in the middle. The vertical line represents the mean or 5oth percentile. Just as importantly, the normal distribution contains two “tails” at the far end of the curve: the one to left representing outcomes that are substantially below average, and the one to the right representing outcomes that are substantially above average. Obviously we as investors would love to be as far to right on the curve as possible because this represents those that have achieved superior investment returns.

Notice how difficult it is to achieve truly distinct outcomes, either good or bad. Most of the outcomes in investing and life are centered around the average. The closer we get to the mean, the greater the number of outcomes we will observe. There is a tremendous unseen force in the world that tries to pull as back to the center or average outcome. This is what we are describing when we talk about “reversion to the mean.”

This reminds me of a saying that in all actuality is quite the redundant non -statement: on average, people are average. From the view of the normal distribution this is an obvious statement. The more we think and behave like others, follow the majority, or adopt popular opinion, the more likely we are to end up smack dab in the middle of the bell curve. In other words, achieve average results.

In order to get into the right hand tail of the distribution you have to break away from the herd. You must develop a unique way of viewing the world that allows for actions that differentiate you from the group. This is the only way to achieve results that are above average—you must think and behave differently.

I want to mention an important point here that shouldn’t be brushed over. While thinking and behaving differently is necessary for us to end up in the right hand tail, this also opens up the possibility of ending up in the left hand tail. One of the defining features of those that have substantially below average results is that they also have chosen to think and act differently. Perhaps this is the reason so many investors fear adopting positions outside the norm. Many investors and professional money managers are fine with a comfortable mediocrity rather than risk the possibility of being wrong and outside the norm.

To Be or Not To Be….A Contrarian

“Be greedy when others are fearful and fearful when others are greedy.”

– Warren Buffet

With this quote Warren Buffett lays out what I believe is a core principle of successful investing: the willingness to go against the thinking of the larger group. If we want to achieve superior results we must follow Buffett’s advice and adopt positions independently, and at times, directly opposed to the position of the majority.

If I had to describe the general characteristic of most people in the investment world it would be trend follower. As discussed above, this causes most people to achieve, at best, average results. It affects financial advisors, analysts, investment managers, business people, and individual investors. As we have discussed, the trend, the consensus view, is something to be met with a healthy degree of skepticism. Our goal is to judge investing from a perspective of an outside observer. The worst thing an investor can do is to get caught up in the fervor of the moment, especially at extremes.

Why does contrarianism work? Let’s think about it specifically in terms of the stock market. The more popular a stock is, the more confident the analysts are, the more everyone knows it is a good investment, the more likely the stock has already been bid up and any excess return has already been eaten up by investors. As I have discussed in other places the objective of investing is to buy things for less than they are worth. The more people that “know” something is a great investment the more likely the price has been pushed up to fair value or beyond. In other words the very fact that a majority of people believe something to be a great investment, many times is enough to limit its profit potential.

Only by going places that are temporarily out of favor will we be more likely to find excess returns. Our objective is to find mispricings in the market. As people become displeased with a stock, selling will likely increase, pushing the price lower. As investors push down the price, the possibility of excess return for those willing to go against the crowd increases. The exact opposite is true in popular or “hot stocks.” They will usually have their prices pushed up by the momentum of the crowd and instead of being a positive, this rise in price is typically drawing against future returns.

Going against the crowd is no easy task. You have to develop a strong enough stomach to depart from the group. This can be especially challenging because the payoff is not immediate. In fact, you may have to wait several years for your reward. This is a lifetime in today’s market where everyone wants to talk about their most recent returns. Contrarianism can reap tremendous rewards because it is so challenging and uncomfortable to do. Because so few people are able to accomplish it, those who are able to can achieve results that end them up in the right hand tail of the distribution.

The Risks of Following The Herd

There is a certain feeling of comfort we get from knowing that other people agree with us. Or alternatively, there is a certain security in knowing that we are doing what other people are doing. Ironically in investing, far from removing risk, following the herd actually increases investment risk.

What is popular is actually risky. If you move in lock step with everyone else, without questioning, the more likely you will follow everyone over a cliff. I have talked many times about the “margin of safety” being the centerpiece of all investing. That is purchasing stocks only at times when the price is at a substantial discount to the value of the underlying business. Following the group or general market sentiment offers no margin of safety. In fact the margin of safety has probably been eliminated as more capital has flowed into a popular investment idea and pushed its price higher.

The more popular a stock is, the more people that believe it is a “sure thing,” the higher the expectations will be for the stock. It is the very fact that no one is questioning the majority position that increases investment risk. There is nothing more expensive in investing than rosy expectations. The higher the expectations, the more likely even a small disappointment will cause a large decline. You should avoid high expectation stocks. Try to find stocks where the future does not have to be all that kind to you. This requires purchasing businesses at a discount, which in turn usually requires some degree of pessimism surrounding a stock, which in turn requires a strong ability to act contrary to the market.

Another risk of following the crowd is what to do when everyone panics and heads for the hills. As investor Howard Marks says, “if something can’t go on forever, it means it will end.” The more you rely on the crowd for returns on the way up, the more you run the risk of being left holding the bag if the crowd suddenly changes their mind. We need to be grounded in an investment philosophy that is much more stable than the whims of the crowd.

Human Nature Makes Thinking and Behaving Differently Difficult

I will briefly talk about why I believe it is so difficult to break away from the herd and achieve above average results. These are forces we are not even conscious of because they are so ingrained in our patterns of thought and behavior. This topic could occupy its own newsletter, so I will speak only broadly here.

1. Biological: Evolution has ingrained in us a tendency to look to others for a quick response. Over millions of years our brain developed shortcuts to process all of the information we are hit with. For most of human history individuals did not have the luxury of calmly and rationally assessing a situation before making a decision. If you saw everyone else running, survival from a probabilistic standpoint was best served by running also. There is also an idea from evolution that we still talk about today: the concept of “safety in numbers.” For much of human history being with a group meant a higher chance of survival. It was the individual that got separated from the group, or deliberately broke away, that was in a high degree of danger. As a result of the forces of natural selection we are hard wired to want to stick with the herd.

2. Social: Human beings are highly social creatures. We enjoy getting approval from others and being part of the “in group.” We like the idea of other people thinking like we do. We also usually find the greatest validation of our actions from the recognition of others. This desire for social acceptance is a constant in life from the junior high kid who wants to sit at the cool table to the successful business person who wants to join the prestigious country club. The social pressure to fit in is incredibly strong. The sad truth is that successful investing is actually quite the lonely proposition. To achieve superior results you will often find yourself challenging the position of the group. You must become comfortable with developing an independent, objective analysis of the situation regardless of what others think.

3. Psychological: I think two psychological forces are relevant in this area. 1) Self- doubt is a very real phenomenon and perfectly natural. We tend to question ourselves and our ability to make decisions. Most people don’t enjoy making decisions under pressure, with limited information, and in situations where the monetary consequences will be great. 2) Although we humans tend to believe we are highly rational, we are very susceptible to conditioning. Going with the current trend is tempting because it may yield an immediate reward. This positive feedback tends to make us want to perform that action again and again. As this repeats we become more conditioned to seeking out an immediate reward which often means joining in with the crowd.

4. Emotional: Human beings tend to suffer from “availability bias.” We believe what is in front of us in the here and now is the most important thing in the world. We overweight available information, and underweight outside information and events in the future. We suffer from a tendency to provide a knee jerk emotional response the moment we are met with information. However, human nature being what it is, we tend to overshoot in both directions. When things are good we tend to be overly optimistic and the human trait that comes out is greed. When things are going poorly we tend to be overly pessimistic and the human trait that comes out is fear. This is why contrarianism is such a crucial aspect of investing. If we are able to keep our head when others are losing theirs, we can take advantage of the temporary market excesses.

Review

• If you simply adopt the position of the majority, the best you can hope for is average results.
• Only by thinking and behaving differently can we hope to break away from the herd and achieve above average results.
• By thinking and behaving differently it opens up the possibility of us being singled out for being wrong. There is a certain sense of security we gain from conforming to the group. This is probably why so few people can truly be contrarian. This probably helps to explain contrarianism’s effectiveness.
• “Be greedy when others are fearful and fearful when others are greedy.” Contrarianism allows us to take advantage of excesses that arise in the market.
• The more popular an idea is, the more likely its profit potential has already been eliminated.
• Popular stocks have an increased risk because of a reduction in the margin of safety, higher expectations, and the possibility the crowd could suddenly change its mind.
• As the group becomes dissatisfied with a stock, pessimism will push the price down to a
• discount, opening up the possibility of excess returns for those willing to step in and act contrary to the market.
• Because of biological, social, psychological, and emotional forces, acting independently of the crowd is challenging. Hopefully by understanding the subconscious forces that push us to conform to the group, we are better equipped to focus our efforts on providing an independent, objective analysis before making investment decisions.
• Always remember the goal of investing is to buy high quality businesses for substantially less than they are worth. That is what should always be front and center.
• Don’t worry about what others think, how many people agree with you, market fluctuations, or short term results.