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Staying Clear of the Madding Crowd


The Making of a Contrarian Investor



by Ronald Chan and Brian Lui

Being a contrarian investor is often dangerous, but it may be necessary to achieve superior investment returns. In this article we explore the notion of contrarian investing and put its principles into perspective. 

 According to Humphrey Neill’s The Art of Contrary Thinking, “to be a contrarian is to train your mind and ruminate in directions opposite to public opinion, then to weigh your conclusions in the light of current events and manifestations of human behavior.”
   
The logic of contrary thinking seems straightforward, but its practice is rather more challenging.

As most of us are taught to conform to societal norms at a young age, we tend to adopt a herd mentality. Contrarians may therefore face extreme social disapproval and feel they’re following an unrewarding path.
   
Economist John Maynard Keynes once said, “Worldly wisdom teaches that it is better for the reputation to fail conventionally than to succeed unconventionally.” The famous Asch conformity experiments carried out in the 1950s clearly demonstrate the aptness of the British economist’s observation.  
   
In this test, which examined how group pressure affects perceptions, psychologist Solomon Asch invited students to participate in a vision test. Only one of the participants in each group was the experiment’s real subject; the others were Asch’s confederates. Each group was asked a variety of questions. All the participants had to say their answers aloud in front of the group, but the confederates had been preselected to answer first. This method ensured that the real subjects knew everyone else’s answers before they gave their own.
   
During the first part of the experiment, Asch asked a question, such as “Which line in the right-hand picture has the same length as that in the left-hand picture?” (See figure, this page.) The confederates answered correctly, as did 97 percent of the real subjects.
   
In the next part, however, the confederates gave an incorrect answer to a similar question. After all seven confederates answered incorrectly, the real subjects followed their peers and also gave the wrong answer. By the end of the experiment, 75 percent of the real subjects had succumbed to peer pressure and provided the wrong answer. The Asch experiments demonstrate that people would rather be wrong as a group than right as individuals.

Meet Mr. Market

Although we know that the power of conformity can dramatically affect an individual’s decisions, for good or ill, we also know that naïvely going against the crowd purely for the sake of it is also a sure path to failure.
   
In the stock market, the crowd is right most of the time. It is when investors and stock experts begin to think with their hearts rather than their heads that they often go wrong. Therefore, prudent investors become contrarians only when the general market sentiment diverges from their own rationally conducted investment analysis.
  
As economists and financial analysts may make overly optimistic or overly pessimistic assumptions in explaining why the market is behaving in a particular way, the true contrarian objectively evaluates where the market should be and then compares it with the general consensus. When the two diverge significantly, it’s sensible to go against the grain.
   
Benjamin Graham, the father of value investing, likes to think of the ever-gyrating stock market as operated by a moody person, Mr. Market. Each day, Mr. Market offers investors stock prices based on his mood. On sunny days, when his mood is bright, he bids up share prices. On rainy days, when he feels gloomy, he sends these prices to depressed levels.
   
By inference, Graham urges investors to think independently, rather than be controlled by Mr. Market. After all, a probing mind is a contrarian mind, and only realistic and careful assumptions about a stock’s valuation count.

Contrarian vs. Value Investing

Many believe that a contrarian investor is equivalent to a value investor, and, to a certain extent, they’re indeed the same. In our opinion, however, the investment decision-making processes of the two deviate from each other. 
   
The value investor tends to focus solely on price versus value. Price is simply what the market is offering for a stock, and the stock’s value is what the investor has calculated based on thorough analysis. When the two figures differ, the value investor acts accordingly.
   
The contrarian investor initially behaves exactly the same way as the value investor. But the contrarian takes public sentiment and analyst expectations into consideration and uses them as valuation metrics. In the process, he puts his own valuation into perspective by comparing it with the market’s view. For example, if the contrarian notices that the market is using unjustified or unrealistic assumptions to value stocks, he uses this as a signal to act.  
   
Contrarian investing can be a powerful tool. By measuring market expectations, the contrarian can get a better sense of when to enter or exit the market. But the madness of the crowd often lasts longer than the contrarian can stick to his principles. After all, hindsight is always 20/20 when deciding that the tide has turned; thus, correctly timing the market seems more of an art than a science. 
  
In this respect, the contrarian mindset should be counted as only one tool in an investment toolbox, not as an all-purpose solution to every situation. In our next article, we’ll use a particular stock as an example to show how the contrarian mindset can be used in everyday investment valuation. 

Ronald Chan and Brian Lui operate Chartwell Capital Limited, an asset management firm based in Hong Kong.




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