On combating negative influences and Contrarianism
In the review of the previous chapters of the book, we dealt with importance of price and the relationship between price and value, then in another post, we dealt with the recognition of risk and the control of risk. In the last post, we considered the cyclical nature of investment markets, and the pendulum like swings between greed and fear, and euphoria and despair.
The next two chapters deal with the negative influences on investor psychology and the need to embrace contrarianism to be successful in markets. Here are the excerpts:
Chapter 10: The Most Important Thing is ……Combating Negative Tendencies
The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—-these factors are near universal. Thus they have a profound collective impact on most investors and most markets. The result is mistakes, and those mistakes are frequent, widespread and recurring.
Inefficiencies—mispricings, misperceptions, mistakes that other people make—provide potential opportunities for superior performance. Exploiting them is, in fact, the only road to consistent outperformance.
Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. Many people will reach similar cognitive conclusions from their analysis, but what they do with those conclusions varies all over the lot because psychology influences them differently. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.
These psychological factors create opportunities for superior investors to augment their results by refusing to hold at the highs and by insisting on buying at the lows. Resisting the inimical forces is an absolute requirement.
The first emotion that serves to undermine investors’ efforts is the desire for money, especially as it morphs into greed. from time to time greed drives investors to throw in their lot with the crowd in pursuit of profit, and eventually they pay the price. The combination of greed and optimism repeatedly leads people to pursue strategies they hope will produce high returns without high risk; It makes them pay elevated prices for securities that are in vogue; and hold things after they have become highly priced in the hope there’s still some appreciation left.
The counterpart of greed is fear—the second psychological factor we must consider. Fear is overdone concern that prevents investors from taking constructive action when they should.
The third psychological factor which clouds investors minds is the tendency to engage in willing suspension of disbelief- people’s tendency to dismiss logic, history and time-honored norms. This tendency makes people accept unlikely propositions that have the potential to make them rich. However, the process of investing requires a strong dose of disbelief. Inadequate skepticism contributes to investment losses.
The fourth psychological contributor to investor error is the tendency to conform to the view of the herd rather than resist—even when the herd’s view is clearly cockeyed. Many people who don’t share the consensus view of the market start to feel left out. Eventually it reaches a stage where it appears the really crazy people are those not in the market.
The fifth psychological influence is envy. However negative the force of greed might be, always spurring people to strive for more and more, the impact is even stronger when they compare themselves to others. People who might be perfectly happy with their lot in isolation become miserable when they see others do better.
The sixth key influence is ego. Investing—especially poor investing—is a world full of ego. Since risk bearing is rewarded in rising markets, ego can make investors behave aggressively in order to stand out through the achievement of lofty results. the road to investment success is usually marked by humility, not ego.
The final influence Marks’ talks about is a phenomenon he calls capitulation, a regular feature of investor behavior late in cycles. Investors hold to their convictions as long as they can, but when the economic and psychological pressures become irresistible, they surrender and jump on the bandwagon.
The desire for more, the fear of missing out, the tendency to compare against others, the influence of the crowd and the dream of the sure thing—these factors are near universal. Thus they have a profound collective impact on most investors and most markets. This is especially true at the market extremes. The result is mistakes—frequent, widespread, recurring, expensive mistakes.
To avoid losing money in bubbles, the key lies in refusing to join in when greed and human error cause positives to be wildly overrated and negatives to be ignored. Doing these things isn’t easy, and thus few people are able to abstain. In just the same way, it’s essential that investors avoid selling—and preferably should buy—when fear becomes excessive in a crash.
Mastery over the human side of investing isn’t sufficient for success, but combining it with analytical proficiency can lead to great results.
Investors who believe they’re immune to the forces described in this chapter do so at their own peril. What weapons might you marshal on your side to increase your odds?
- a strongly held sense of intrinsic value
- insistence on acting as you should when price diverges from value, • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded
- a thorough understanding of the insidious effect of psychology on the investing process at market extremes
- a promise to remember that when things seem “too good to be true,” they usually are
- willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and
- like-minded friends and colleagues from whom to gain support (and for you to support).
Chapter 11: The Most Important Thing is ………Contrarianism
There’s only one way to describe most investors: trend followers. Superior investors are the exact opposite.
Doing the same thing others do exposes you to fluctuations that in part are exaggerated by their actions and your own. It’s certainly undesirable to be part of the herd when it stampedes off the cliff, but it takes rare skill, insight and discipline to avoid it.
the key to investment success has to lie in doing the opposite: in diverging from the crowd. Those who recognize the errors that others make can profit enormously through contrarianism.
Buy low; sell high” is the time-honored dictum, but investors who are swept up in market cycles too often do just the opposite.
market extremes seem to occur once every decade or so—not often enough for an investor to build a career around capitalizing on them. But attempting to do so should be an important component of any investor’s approach.
Just don’t think it’ll be easy. You need the ability to detect instances in which prices have diverged significantly from intrinsic value. You have to have a strong-enough stomach to defy conventional wisdom (one of the greatest oxymorons) and resist the myth that the market’s always efficient and thus right. You need experience on which to base this resolute behavior. And you must have the support of understanding, patient constituencies. Without enough time to ride out the extremes while waiting for reason to prevail, you’ll become that most typical of market victims: the six-foot-tall man who drowned crossing the stream that was five feet deep on average.
Accepting the broad concept of contrarianism is one thing; putting it into practice is another. On one hand, we never know how far the pendulum will swing, when it will reverse, and how far it will then go in the opposite direction. On the other hand, we can be sure that, once it reaches an extreme position, the market eventually will swing back toward the midpoint (or beyond).
On the third hand, however, because of the variability of the many factors that influence markets, no tool—not even contrarianism—can be relied on completely.
Contrarianism isn’t an approach that will make you money all of the time. Much of the time there aren’t great market excesses to bet against.
Even when an excess does develop, it’s important to remember that “overpriced” is incredibly different from “going down tomorrow.” • Markets can be over- or underpriced and stay that way—or become more so—for years. • It can be extremely painful when the trend is going against you.
If you look to the markets for a report card, owning a stock that declines every day will make you feel like a failure. But if you remember that you own a fractional interest in a business and that every day you are able to buy in at a greater discount to underlying value, you might just be able to maintain a cheerful disposition.
it’s not enough to bet against the crowd. Given the difficulties associated with contrarianism just mentioned, the potentially profitable recognition of divergences from consensus thinking must be based on reason and analysis. You must do things not just because they’re the opposite of what the crowd is doing, but because you know why the crowd is wrong. Only with the confidence created by a strong decision-making process can investors sell speculative excess and buy despair-driven value.
The ultimately most profitable investment actions are by definition contrarian: you’re buying when everyone else is selling (and the price is thus low) or you’re selling when everyone else is buying (and the price is high). These actions are lonely and, uncomfortable. What’s clear to the broad consensus of investors is almost always wrong. … The very coalescing of popular opinion behind an investment tends to eliminate its profit potential.
Most people seem to think outstanding performance to date presages outstanding future performance. Actually, it’s more likely that outstanding performance to date has borrowed from the future and thus presages subpar performance from here on out.
Superior investors know—and buy—when the price of something is lower than it should be. And the price of an investment can be lower than it should be only when most people don’t see its merit. Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.
there are two primary elements in superior investing: seeing some quality that others don’t see or appreciate and having it turn out to be true (at least have the market accept it as true).
Every time a bubble bursts, a bull market collapses or a silver bullet fails to work, we hear people bemoan their error. The skeptic, highly aware of that, tries to identify delusions ahead of time and avoid falling into line with the crowd in accepting them. So, usually, investment skepticism is associated with rejecting investment fads, bull market manias and Ponzi schemes.
In dealing with the future, we must think about two things: (a) what might happen and (b) the probability that it will happen.
In general, following the beliefs of the herd—and swinging with the pendulum—will give you average performance in the long run and can get you killed at the extremes.
Only a skeptic can separate the things that sound good and are from the things that sound good and aren’t
skepticism and pessimism aren’t synonymous. Skepticism calls for pessimism when optimism is excessive. But it also calls for optimism when pessimism is excessive.
The herd applies optimism at the top and pessimism at the bottom. To benefit, we must be skeptical of the optimism that thrives at the top, and skeptical of the pessimism that prevails at the bottom.
Not only should the lonely and uncomfortable position be tolerated, it should be celebrated. The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.
Thus, a hugely profitable investment that doesn’t begin with discomfort is usually an oxymoron.
It’s our job as contrarians to catch falling knives, hopefully with care and skill. That’s why the concept of intrinsic value is so important. If we hold a view of value that enables us to buy when everyone else is selling—and if our view turns out to be right—that’s the route to the greatest rewards earned with the least risk.