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.
Five RIsks of Contrarian Investing,
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Hi Rob–With all the caveats listed I still feel that in the long run, the contrarian investor comes out ahead. People invest with the herd because it seems “right”. During long bull markets, stock prices rise steadily almost mimicking the high interest CDs of the 1980s. That lulls people to sleep, setting them up for big hits when the dynamics reverse. Equity markets are volatile by they’re very nature, and the complacency that sets into long bull markets makes the fall even greater.
The contrarian can beat this because he understands the volatility factor, even when the markets are “behaving”. He’s an opportunist, playing the very volatility that the herd pretends isn’t real. The contrarian is very much a sophisticated investor, more attuned to what is happening than the more passive herd investors. Just my two cents!
Thanks much for stopping by, Kevin. It’s always great to hear your voice.
Rob
Rob,
Does the similar approach apply/work in the markets outside of US?
Thanks,
Mark.
Mark:
Thanks for stopping by.
Are you asking if Valuation-Informed Indexing (VII) works outside of the United States? That’s the strategy I advocate. I am checking to be sure because this article discussed VII only tangentially.
If that’s your question, my answer is a tentative and caveated “yes.”
The purpose of academic research is to learn how stock investing works. Most of the research focuses on the S&P 500. Not because all investors invest in the S&P 500. The reason for the focus is that we have the best dataset for the S&P (we have records going back to 1870). You want to do research using a dataset. If the conclusions drawn from examination of that dataset are valid, they will apply to all non-S&P markets too.
Now for the caveats. We have 140 years of data for the S&P. That’s good. But it could be argued that it’s not good enough. It would be better if we had 1,400 years of data or 14,000 years of data. Then we could have more confidence in our conclusions. I believe that the research is valid. But I also believe that the responsible thing is to note that the dataset is not as big as we would like it to be. So we should consider the conclusions drawn from use of the research to be at least somewhat tentative ones. Subsequent research might tell a different story.
Shiller did some research into non-U.S. markets and other researchers have done this too. You can look that stuff up in Shiller’s book or with a Google search. You won’t come up with anything 100 percent dispositive. Think about emerging markets. What can you really say about them? They haven’t been around long enough to have datasets that can produce findings worthy of much consideration. You would not expect emerging markets to perform as established markets perform and indeed they do not.
My overall take re all this is that the state of the world’s understanding of how stock investing works is today primitive. We have made some huge leaps in recent decades. Buy-and-Hold was a huge advance over what was available to us in earlier days (Buy Low/Sell High). Valuation-Informed Indexing is a huge leap over Buy-and-Hold (in my view!). But we don’t know it all today and we cannot know it all today or anytime soon no matter how hard we try.
We all need to adopt less dogmatic takes re stock investing and to try to remain as open as possible to truly hearing what the other fellow has to say. Please understand that that goes for Rob Bennett as much as for anyone else.
Rob
Thanks, that was my question exactly. I am from Canada and my portfolio is split between Canadian , US, and international markets (no emerging markets) and I was thinking if I could use this approach to set individual allocations. The pe10 data for S&P500 is readily available. Cannot say the same about the Canadian & International indexes though…
Although all the markets are quite correlated now…
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