Contrarian investing: dangerous or rewarding?

Some say that contrarian investing _ investing that goes against prevailing market trends _ is playing with fire. The very few others, who are successful contrarians, simply take it in their stride and enjoy their achievements. You have often heard me say that the only constant is change. When it comes to investing, many individuals have trouble dealing with change; they are too subjective about their asset allocations and what they ought to be doing. In this respect, you can actually be your own worst enemy. Failure to constantly monitor your portfolio to ensure that change is accounted for can be fatal.

Psychologically we see losses emotionally and gains logically. This means that we are able to count gains and quantify them, making us understand the realities of what is happening. However, when it comes to facing losses we use a different part of our brain _ the emotional area. This starts a diverse response within our thinking and magnifies the facts way beyond logical thinking. This phenomenon, known as loss aversion, explains why people do not make changes within their portfolios when necessary.

Now take this logic and project it forward rather than looking at these factors historically. We are usually so averse to suffering losses that we become conservative with investment strategies in a practical sense. This leads to our making the wrong decisions at the wrong times, resulting in losses when there really would be no need to make any. This behaviour is simply following the herd.

I often refer to this phenomenon because most of us think emotionally and feel comfortable doing what others are also doing. That sense of "being the same as others" makes us feel secure inside and until we realise just how we could have done things differently, we feel sheltered. Loss aversion multiplies the desire to stay with the herd and removes all logic from our decision making process about our investments deferring to subjective choices.

Some of the masters of efficacious investing have nerves of steel and can view the determinations they make without being emotionally involved at all. This enables them to achieve consistently good results. People like Warren Buffett know what to do by using logical thinking. I frequently discuss Mr Buffett's investment strategies with other expats. They know that it is highly probable that the tactics Mr Buffett uses will be successful. These expats see the logical sense in the decisions he makes and in his strategic forward planning. However, ask the same investors to follow that strategy and they come up with many different excuses not to do so. This is their emotional "loss aversion" emerging and coming to the fore of their thinking.

While the logical argument for your asset allocation is sensible, most people see different timelines and horizons from what should be the norm when they are considering their investments. "It looks as though markets will fall so I prefer not to buy in," is a common attitude. When markets start to climb, their view changes to: "It's probably too late now because I have lost that imperative initial momentum."

What the investor does not see is the reality that equity markets are a long-term buy and hold. Equities will be volatile in the short term; over a longer period this is not the case. Stock markets have grown on a long-term basis since records have been kept. If you look at a graph of the markets (such as the Dow in the chart) from 2008 up to today you will observe that the major dip during the 2008 recession was a decline that is beginning to become less significant in the big picture.

Thus volatility in the short term is the norm rather than the exception. On a longer-term basis, equities will rise. Then the herd panics because they see a blip in the fundamentals and many investors blindly follow the charge. This results in their going in and out of the market, often at the exact worst times.

Equities tend to rally quickly because of their short-term volatility. Thus the best way to use equities within your investment portfolio is to have time in the market. Timing your moves into and out of the market is a fool's game. Historically, investors have been apt to move into cash in a bear market and then miss the bull runs because they were too late.

Taking an example of a retiree, who has a reasonable nest egg and wishes to create a long term strategy to use his life savings sensibly, many investors and even advisers would opine that it's best to be conservative or even a little balanced but to ensure that capital is preserved for the future as it cannot be replaced with future earnings.

In fact, one of the best strategies is to mix the risk into areas relating to time horizons. For short-term use, cash deposits may be best, ensuring the correct liquidity for immediate access to funds when required. In the plan this allocation would be sizeable enough to be usable for at least two or maybe three years, and would allow the remainder of the portfolio to grow without the need for use of the assets over a longer timeline that is more successful to its asset class.

For the medium term, bonds and dividend-paying assets will be useful in that they will produce income that can be accumulated in preparation to be drawn as required. The underlying assets will be part of the remainder of the portfolio.

If invested in equities with at least a six- to eight-year growth horizon, the value of these assets by the time you seek to use the funds will likely have grown and the resulting income will be more substantial.

As time moves on and cash reserves deplete over the initial three years, the proportions of your allocations can be rebalanced to extend the equity allocation with a smaller portion and give the portfolio more longevity. In many ways this seems a very logical strategy. However, the emotions of the investor tend to use him to consider only capital preservation rather than the reality of occasional declines and recoveries, which is the nature of the beast. The emotions will pull him up short and he will require an even bigger nest egg to last him through his golden years than the contrarian who is only following logic.

Too many individuals have this tendency and it is understandable. The wiser among these expats employ the services of an adviser to ensure that the detailed decisions are not subject to unnecessary emotional pressure that saps willpower and causes decision fatigue.

Most of you fall into this category and ultimately make up the "herd" that charges on toward oblivion, creating havoc within itself. However, if the herd didn't exist, there would be less success for the contrarians.


Andrew Wood has been an expat in Asia for 33 years and is executive director of PFS International. His articles, which cover the complete A-Z of financial planning, are available through the PFS library to readers on request. Questions to the author can be directed to PFS International on 02-653-1971 or emailed to enquiriesthailand@fsplatinum.com.

About the author

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Writer: Andrew Wood
Position: Writer