It would be fair to describe me as a contrarian investor. I advocate Valuation-Informed Indexing. Valuation-Informed Indexers go with high stock allocations when prices are low (which means most investors are not happy with stocks) and with low stock allocations when prices are high (which means that most investors love stocks).
Still, I am not a pure contrarian. I see five potential dangers.
1) The Momentum Going Against You Might Be More Powerful Than You Realize
The logic of Contrarian Investing is that, when prices get too high, they sooner or later must come down, and when prices get too low, they sooner or later must rise. The trouble is that there is also a logic to Momentum Investing, the idea of going with the herd. Once investors start leaning in one direction, they are inclined to lean harder and harder in that direction for some time.
In 1996, stock prices reached insanely dangerous levels. Some contrarians shorted the market. They were killed. Stocks went up big time in 1996, 1997, 1998 and 1999. Stock prices continued going up even after reaching levels never seen before. The contrarians were eventually proven right. But how many of them were wiped out before valuations began heading downward in 2000?
2) Contrarian Investing Is Lonely Investing.
Contrarian Investing looks great on paper. It is often a lot harder to pull off in real life than those drawn to it anticipate. Humans are social creatures. We are influenced by what people around us are thinking and saying. Some of us can manage to hold to contrarian positions for a limited amount of time. But success with Contrarian Investing sometimes takes a level of independent thought that few humans possess.
Give up on your Contrarian Investing plan just before prices turn and you can experience the worst of all worlds. You might miss out on years of gains while prices move steadily upward and then see prices crash soon after you throw in the towel on what you thought was a great idea that you felt forced to abandon because it did not pa off for so long.
3) Sometimes the Crowd Is Right.
The crowd is not always right. Stock prices had been increasing for many years in the early 1990s and many contrarians thought it was time for a shift downwards. But stocks were not yet priced at insanely high levels. Stocks had been priced so low in the early 1980s that even years of great returns had not left stocks so overpriced that additional gains were not possible. The crowd was excited about stocks in the early 1990s. It was right to be.
The same may well be true today. Money invested in stocks has been dead money for 12 years. Stock investors are getting depressed. Some contrarians think it is a good time to make a big bet on stocks. But stock prices usually fall to far below fair value in the wake of huge bull markets. It’s entirely possible that we are still in the early years of the biggest bear market ever seen. Those who get in now might be showing up just in time to get their heads cut off.
4) Big Gains Come At the Expense of Other Investors.
Contrarians make out best when lots and lots of other investors make big mistakes. They serve a purpose by doing that. Contrarian Investing adds balance to the market. But Contrarians cannot help but getting excited when they see prices go insanely high or insanely low. It is at the extremes that Contrarian Investing works best.
Valuation-Informed Indexing is different. One of the goals of Valuation-Informed Indexers is to create tools showing investors the benefits of taking valuations into consideration when setting their stock allocations. If most investors became Valuation-Informed Indexers, we would never again see a runaway bull market or a runaway bear market.
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I don’t like the big gains that can be earned through use of Contrarian Investing strategies when the market is at extreme price levels. I worry that excessively high prices will cause an economic crisis that will become so bad that it will end up costing me more than the gains I made through the use of contrarian strategies.
And I view excessively low prices as just insane. We end up spending trillions in stimulus spending when prices go so low that policymakers worry that we may enter an economic depression. The wastefulness of prolonged recessions helps no one. And extreme market prices are the primary cause of prolonged recessions, in my assessment.
5) You May Outsmart Yourself
Contrarian Investors are smart. Perhaps too smart. You know that saying “it’s not nice to fool Mother Nature”? The investing equivalent is “It’s not nice to think you can know in advance where the market is headed.” Start thinking you have it all figured out and you will be tempted not only to profit from the reality that what goes up sooner or later must come down but also from your genius ability to know when it is going to start coming down. When it comes to short-term timing, I am in the camp of the Buy-and-Holders in believing that, no matter how appealing it may be to try, it really cannot be done successfully even by the smartest of investors.
Rob Bennett often writes about how to achieve financial independence early in life. His bio is here.