The Chasm between Theory and Practice of Contrarian Investment

Contrarian investing is simple to appreciate and can lead to meaningful wealth creation. However, even as it seems simple as a concept it takes extreme discipline and will power to practice. It is difficult to follow due to the way we human beings are wired – to always think that we are different from consensus and that we are right, our inability to predict how we shall behave in future, and our reluctance to play even favourably biased games when in an extreme situation.

Bias blind spot: The irony of herd behavior
Devastation due to bubbles in financial markets – or on the other extreme, our inability to benefit from sharp slump in asset prices – are mostly driven by lemming behaviour. Ironically even while blindly following the herd – often to disaster, most of us tend to think that we are different from consensus, and that consensus is wrong (or rather, we are right).
This behaviour, known as bias blind spot in behavioural finance terminology, is a cognitive bias due to which one is unable to spot the impact of biases on one’s own judgment even though one feels that one recognizes the impact of bias on others’ judgment. This hinders the ability to analyse if the path being followed is right.
So how does someone who is late to a stock market rally (which may be peaking) justify one’s fresh buying? Simply, by concluding that consensus is too pessimistic and is unable to see the blue sky scenario that one “knows will happen”.

Empathy gap: On a sunny day do I know, how will I behave on a cold rainy day
Empathy gap- which occurs when human understanding is state dependent i.e when someone underestimates the influence of visceral states on one’s choices – is another behavioural bias that prevents investors to defy the crowds even if there is strong evidence. It is like finding it difficult to imagine being happy at a point when one is angry. Another example can be the situation where after a heavy meal one can’t even think of eating something in future.
In real life situation, we all are perennially waiting for the equity markets to tank by Say, 25% so that we can load up on stocks paving the way to a wealthy retired life. Unfortunately empathy bias often sets in, in the event of a 25% slump in markets. When experts are discussing doomsday scenario on business TV channels, when newspapers are full of stories of mayhem on the ground, and when companies are sounding extremely pessimistic we as general investors are unable to even try to think otherwise. In such a situation if at all we try to apply our mind it is mainly to justify why the current gloomy situation will sustain for foreseeable future.
These are the occasions which investors wait for, where well thought contrarian moves can drive solid wealth creation and where our inner biases prevent us. However even for the most disciplined investors it is not easy to defy this empathy bias.

Terminal paralysis: Fear of pulling the lever
Let’s assume we manage to overcome bias blind spot and empathy bias. However there is one more troll for a contrarian investor. The environmental bias in extreme circumstances (a roaring bull market or a limping bear market) are so strong that even if we push ourselves to do some proper analysis, or even if someone else highlights some obvious stock opportunity with solid arguments then too we won’t act. Terminal paralysis prevents us from acting even on favourably loaded games if environment is adverse.

So how to avoid these behavioural mine fields?
To be able to think and act in an extreme environment we need to be aware of these biases first. Conscious thinking and will power can help us overcome bias blind spot and empathy gap- at least partially. However every such occasion will need a fresh stock of will power.
On the action part a good way to defy terminal bias is effectively to tie oneself to the proverbial pole on the ship – like Odysseus, to avoid falling for siren songs. If we are ready with names of stocks that can offer good entry opportunity at certain price point then it is easier to take action when those price points are achieved – irrespective of market environment.
Legendary investor John Templeton, sensing this human weakness, used to do his research in normal environment in a cold, rational state when nothing much was happening in the markets– not in extreme market conditions. Thus before the onset of bear markets he was ready with his picks with rough price ranges where he would buy them. Once he got his prices he would go ahead and buy the stocks. Thus advance research and pre-commitment to follow one’s analysis are the keys.

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One thought on “The Chasm between Theory and Practice of Contrarian Investment

  1. An example of Empathy Gap was witnessed recently when Nifty hit around 6900 mark on India’s budget day (2016). Almost fallen 22-23 % from its peak. And as market always behaves Nifty has almost recovered what it lost now.
    • I remember many reputed business news channels/analysts/experts were doubtful of equity as an asset class for investment and analyzing other asset class to invest (it was all happening around budget time-2016).
    • Heard one of the best minds in the industry saying (when Nifty hovered around 7000) if it falls another 10% sell your homes and invest in equities!! Looked weird that time. But he made lot of sense in his weirdness. And it took number of years for him to dare make such statement.
    • Fear many investors had what if it falls another 10-15 %? Yes, true but for investors who had done their homework and picked their stocks and target price would have gone ahead and bought it symbolizing “Be greedy when others are fearful”. Also, for mid-term/ long term investor who doesn’t have MTM related issues should utilize these opportunities and capture it with both hands. No problems even if it comes down another 5-10%. Market doesn’t give these opportunities regularly.
    • Even for traders and short term players there was opportunity to buy Call Options. (with TP and SL in mind).
    • The more recent one on BREXIT result day. It would have been wise to buy vanilla Put, or go for Long Straddle or Long Strangle (for safer bets) when writing was on the wall. (This point is intended for Traders)
    • As they say there is no perfect buying or selling level. It’s all about analyzing risk-reward (price, time, quantum and time horizon). Easier said than done !!!

    Liked by 1 person

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