The Psychology of Contrarian Investing

23.5.
2015
ThePsychologyofContrarianInvesting
CURRENTS | DECEMBER 2013
PhilipLawton
RAFIFUNDAMENTALINDEX
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Behavioralfinance,broadlydefined,hasgivenusafairlycomprehensiveunderstandingofinvestorsrealdecisionprocess
timeworn fiction of economic manthe wellinformed, utilitymaximizing homunculus with stable preferences and supe
morerealisticmodelsofchoiceunderrisk.1 Investors, we now see, are prone to cognitive errors, reluctant to realize los
abilitybutfearfulthatothermarketparticipantsknowsomethingtheydont.Moreover,investorsseeknotonlyutilitarianre
benefitsaswell,suchasstatusandasenseofbelongingtoacommunity.2ThankstoHerbertSimon,DanielKahneman
manyothers,wehaveageneralpsychologythatilluminatesthecognitiveandaffectiverecessesofinvestmentdecisionm
Contrarian investors can be situated within the framework of the general psychology there is no need for an abnormal
behavior. A contrarian stance is not a symptom of a personality disorder. If some contrarians are antisocial or apathe
investors,theyarepeople.Nonetheless,contrariansmayreasonablybeexpectedtosharesomeabidingpersonalitytrait
penchantforcriticalthinking,andastrongfuturetimeorientation.
Mylimitedobjectiveinthisshortpieceistosuggestsomepossibledirectionsforexperimentalresearchonthepsychology
Howard provides a useful frame of reference in his important 2013 paper on behavioral portfolio management (BPM). Hi
crowdsfocusesoncertaincharacteristicsthatmayhelpdifferentiatethehypotheticalattributesofalifelikecontrarian.
EmotionalCrowds
InHowardsaccount,thefirstprincipleofBPMisthatsecuritypricesarepredominatelysetbyemotionalcrowdscompr
saledecisionsarebasedonheuristicshortcuts,anecdotalevidence,andvisceralreactionstounfoldingevents.3Interms
investors operate primarily at the level of System 1: their thinking is fast and automatic.4 Emotional crowds, Howard s
deepseatedaversiontoshorttermlossesandacompulsiveneedforsocialvalidation.5
BPM assumes, as others have established, that markets are not very efficient. Nor are emotional crowds wise in the s
marketparticipantsvaluationswouldtendtoapproximatesecuritiestrue,fundamental,orinherentvalues.6 JamesSuro
characterize wise crowds: diversity of opinion, independence, decentralization, and aggregation.7 Emotional crowds in t
two conditions participants can draw on their own resources, and there is a mechanismthe pricing mechanism
http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/C_2013_12_Psychology_Contrarian_Investing.aspx
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judgmentstoacollectivedecision.Butemotionalcrowdsareunlikelytoexhibitastrongdiversityofopinion,andtheirme
in Surowieckis sense. It cannot be said that peoples opinions are not determined by the opinions of those around t
crowds,peopletaketheircuesfromoneanother.Theythinkwhattheythinkothersthink.
Forthepresentpurpose,itisenoughtotreattheemotionalcrowdasanassemblyofundifferentiatedinvestors.Indeed,fro
fitting the self can be submerged and carried along in a mass movement. Nonetheless, a more granular description of
lines,forinstance,ofAndrewLosspeciesofinvestors)8mightfacilitateempiricalresearchandleadtofurtherinsights.T
followingstrategyconstituentweightsriseandfallwithpricesanditcontributestostockmarketvolatility,9butpassive
totheemotionalcrowd.Thedecisiontoinvestpassivelydoesnot,initself,indicateanythingaboutanindividualscognitiv
Howards view of the pricesetting mechanism does not rule out the possibility of rational investing. It does, however,
investmentdecisionmaking.Inthisview,rationalinvestorsarecontinuallyawareofothermarketparticipantstendencies
investors also recognize that their own emotions are at work, but they try to bring them to the surface and subject th
market prices are not primarily based upon economic forecasting or security analysis, rational investors today are at le
behavioralsignalsastheyarewithassetclasscorrelationsordiscountedcashflows.Howardcallsthembehavioraldata
theircognitivestyleasSystem2thinkingeffortful,highconcentration,andcomplex.11
Howardssecondbasicprinciple(ofthree)isthatBDIsearnsuperiorreturns.Thereis,however,acertainemotionalcost.
Itwouldseemeasytobuildsuperiorperformingportfolios,butdoingsowouldmeantakingpositionsthatareoppo
needforsocialvalidationactsasastrongdeterrentformanyinvestors,discouragingthemfrompursuingsuchan
leavetheemotionalcrowdandbecomeaBDI.12
Howarddoesnotsimplyidentifyrationalinvestingwithcontrarianinvesting(takingpositionsthatareoppositethecrowd
broaderandmorenuanced.13 Nonetheless, in his framework, contrarians can qualify as rational investors. Let us consid
attitude,andbehaviorfromthemembersofemotionalcrowds.
AContrarianPerspectiveonPrices
Asuperficialstatementofthecontrarianpositionwouldsimplyholdthattheemotionalcrowdisfoolishandwillsoonerorla
therearecontrarianswhoearnsuperiorlongtermreturnswithoutmuchmentaleffort.Nonetheless,ifthecontrarianappro
pricingmechanismcanbearticulatedandjustified.
One important version of contrarian investment theory sees security prices as noisy. In information theory, noise in
informationbearingsignal.(Figure1.)Thinkofstaticinterferingwitharadiobroadcast.
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Byanalogy,inmodernportfoliotheory,financialmarketsthetransmissionchannelsareatleastfairlyefficient(orclear)
information (or news). In the contrarian view, however, markets are more than a little inefficient because many participa
static.Perhapstheythinkthenoisetheyaretradingonisinformation,wroteFischerBlack.Orperhapstheyjustliketot
In addition, the contrarian approach (unlike BPM)15 recognizes that, although stocks exhibit shortterm momentum, ove
equitymarketandthepricesofindividualsecuritiesaremeanreverting.16Empiricalstudiesdemonstratethatstockswho
pronounced tendency to turn around and head in the direction of their long term average prices. For example, Fama a
evidence that stock returns are positively serially correlated over short horizons, and negatively autocorrelated over lo
continueforupto10years,butthestrongesteffectshowsupovertheperiodfromtwotofiveyearsafterareversal.
Contrarianinvestorsprofitfromlongtermmeanreversioninnoisysecuritypricesbycontratradingagainstpricewhenth
context,rebalancingmeanssellingwinners(stockswhichhaveappreciated)andbuyinglosers(stockswhichhavelately
likelytobeovervaluedlosers,undervalued.Contrarianinvestorsareunaffectedbysubsequentmeanreversionintheove
divested, and they stand to gain if and when the undervalued, lowprice stocks reverse direction and start to rise. Iro
positionsoppositetheemotionalcrowdsimplycomesdowntobuyinglowandsellinghigh.Contrariansareeminentlyrati
With this background, lets explore how contrarian investors might differ from the emotional crowd along the two key
identified.Arecontrariansalsolossaverse?Dotheystandequallyinneedofsocialvalidation?
ShortTermLossAversion
Peopletypicallylovetowinandhateevenmoretolose.Winningisrewardingitmakespeoplefeelgoodaboutthemselve
disappointing outcome with a certain cost it can be sharply experienced as a selfinflicted insult to the ego, particularly
framedthecompetitionasasingularlyimportantevent.Kahnemansaid,Whenyousellaloser,youdontjusttakeafina
lossfromadmittingyoumadeamistake.Youarepunishingyourselfwhenyousell.20
Loss aversion refers to the experimentally established fact that decision makers have a natural tendency to weigh losse
Thaler states, losses hurt roughly twice as much as gains feel good, and he observes that even investors with long
shorttermgainsandlosses.21
Contrarianinvestorsmaysustaindeepmarketvaluelosses,buttheyaregenerallyinpositiontosidesteptheunderlyingp
investorshavetocontend:overcomingtheirreluctancetorealizealoss.Rebalancingacontrarianportfolioentailsselling
andreinvestingtheproceedsinlowpricestocks,includingthosewhosemarketvalueshaverecentlydeclined.Consequ
likelytorealizegainsthanlosses.
Nonetheless, contrarians do not avoid absolute market value losses in bear markets, and they may have to tolerate
underperformancewhenpricesaretrendingupward.Iftheyaresomewhatlessvulnerabletoshorttermlossaversion,itis
alongterminvestmentstrategyanditispossiblethatthischoicereflectsapersistentattitudetowardthefuture.Joseph
personalityandmotivation,wrote,Generallyspeaking,onecouldsaythatthefutureisthementalspaceinwhichhuman
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personalityandmotivation,wrote,Generallyspeaking,onecouldsaythatthefutureisthementalspaceinwhichhuman
goalsandbehavioralprojects.22
Althoughthefutureisamentalrepresentation,itappearstohavegreaterrealityforachievementorientedpeople.Indeed,
individuals outlook on the future and their selfunderstanding as active persons in a dynamic relationship with the wor
studies reveal that, while some subjects see the future as determined by chance, others regard it as largely dependen
hazardthatactivelongterminvestorschieflybelongtothelattergroup.
In principle, surveys and experiments could establish whether contrarian investors have a greaterthanaverage fut
measurement issues are thorny, especially when future time orientation is considered as an abiding personality trai
experimentally induced response.24 Future time orientation may also be strongly influenced by cultural and historical fa
averagesfromstudiesconductedinBelgiuminthe1980sandtheUnitedStatesinthe2010s.
SocialValidation
Investments are risky thats in the nature of the game. But investment decisionmaking itself is fraught with unc
assumptions(AmIusingtherightdiscountrate?)orexperiencemisgivingsabouttheirknowledge(Whyistheothersid
And,asRobertCialdiniexplains,itispreciselyinsuchconditionsofuncertaintythatpeopleturntotheprincipleofsocia
wayswegoaboutdeterminingwhatiscorrect,orwhattodo,istoseekoutwhatotherpeoplethinkisright.Ingeneral
ourselves,whenthesituationisunclearorambiguous,whenuncertaintyreigns,wearemostlikelytolooktoandacceptth
AdamSmithremarkedthatthemorewemistrustourownfeelingsandopinions,themoreweightwegiveothers.Inhiswo
Theagreementordisagreementbothofthesentimentsandjudgmentsofotherpeoplewithourown,is,inallcase
moreorlessimportancetous,exactlyinproportionasweourselvesaremoreorlessuncertainaboutthepropriety
abouttheaccuracyofourownjudgments.26
The question for a psychology of contrarian investing is whether contrarians are less influenced than average mar
sentimentsandjudgments.Ihavementionedthatactivelongterminvestors,ingeneral,seemlikelytobelievethattheirb
future. This perspective implies a proactive attitude and a certain selfreliance.27 It seems reasonable to anticipate tha
gatherinformation,analyzeit,andreachanindependentconclusion.Italsoseemssensiblenottoexpectthesameofth
maytendtoseementaleffortasanavoidabletransactioncost.RecallthatSystem1istheircharacteristicmodeofthinkin
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Withinthefinancialservicesindustry,allinvestmentprofessionalsareethicallyobligatedtousereasonablecareandexerc
isnoapriorireasontosupposethatcontrariansaredistinctivelyless(or,forthatmatter,more)reliantuponsocialvalidatio
Conclusion
Taking investment decisions seriously means not only acting competently but also understanding and accepting the
choiceswhoseoutcomescannotbeknowninadvance.Thisistoughonallinvestors,butarguablyhardestoncontrarian
superior returns over full market cycles, they fall behind (and managers risk losing clients) when stocks are rising and
Contrarian investors might sometimes feel isolated and embattled. It is natural to wonder whether they have characteri
thoughtthatuniquelyequipthemtohandlethestressofstandingagainsttheemotionalcrowd.
At least one way of articulating contrarian thought sees security prices as noisy and meanreverting. Adopting this vie
personalpreference,butitisnotapurelyarbitrarychoicenoiseinpricemodelshaveproventheoreticallysoundandem
termoutperformanceofcontrarianinvestingdependsuponprofitingfrommeanreversionatthelevelofthemarketand/ori
points out, the emotional cost of the contrarian strategy may be reduced by investing in a transparent fundamental
rebalancesthroughrulesbasedtradingagainstpricemovements.28
Finally, I have suggested that contrarian investors may exhibit a number of normal traits to a higherthanaverage degre
relianceandcriticalthinking,anactiveorientationtowardthefuture,andarelativelylowneedforsocialvalidation.Hypothe
contrariansactuallyhavethesecharacteristics.
References
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Cialdini,RobertB.2009.Influence:ThePsychologyofPersuasion.Revisededition.NewYork:HarperCollinsebooks.
Fama,EugeneF.,andKennethR.French.1988.Dividendyieldsandexpectedstockreturns.JournalofFinancialEcon
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http://dx.doi.org/10.2139/ssrn.2210032.
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Kahneman,Daniel.2011.Thinking,FastandSlow.NewYork:Farrar,StrausandGiroux.
Kalesnik,Vitali.2013.SmartBetaandthePendulumofMispricing.SimplyStated,ResearchAffiliates(3rdQuarter).
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Lane,RobertE.1991.TheMarketExperience.Cambridge:CambridgeUniversityPress.
Larson,Ryan.2013.HotPotato:MomentumAsAnInvestmentStrategy .Fundamentals,ResearchAffiliates(August).
Lo,AndrewW.2004.TheAdaptiveMarketsHypothesis:MarketEfficiencyfromanEvolutionaryPerspective.Journalof
Nuttin,Joseph,withthecollaborationofWillyLens.1985.FutureTimePerspectiveandMotivation:TheoryandResearch
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Robinson,Joan.1962.EconomicPhilosophy.NewBrunswick,NJ:TransactionPublishers.
Shannon,ClaudeE.andWarrenWeaver.1963.TheMathematicalTheoryofCommunication.UrbanaandChicago:Unive
Simon,HerbertA.1955.ABehavioralModelofRationalChoice.QuarterlyJournalofEconomics,69/1,99118.
Smith,Adam.17591982.TheTheoryofMoralSentiments.EditedbyD.D.RaphaelandA.L.Macfie.Indianapolis,IN:
Statman,Meir.2011.WhatInvestorsReallyWant:DiscoverWhatDrivesInvestorBehaviorandMakeSmarterFinancialD
Sullivan,RodneyN.andJamesX.Xiong.2012.HowIndexTradingIncreasesMarketVulnerability.FinancialAnalystsJo
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Endnotes
TheauthorwouldliketoacknowledgethoughtfulcommentsandsuggestionsfromDenisChaves,VitaliKalesnik,EnginKose,MicheleMazzoleni,andK
1Simon(1955)wrote,Broadlystated,thetaskistoreplacetheglobalrationalityofeconomicmanwithakindofrationalbehaviorthatiscompatiblew
computationalcapacitiesthatareactuallypossessedbyorganisms,includingman,inthekindsofenvironmentsinwhichsuchorganismsexist.(Page9
debunkedthemetaphysicalconceptofutility,andKahnemanandTversky(1979)roundlydemonstratedtheinadequacyofutilitytheory.
2Statman(2011),Introduction.
3Howard(2013),57.
4Kahneman(2011),2022.KahnemanattributesthetermsSystem1andSystem2topsychologistsKeithStanovichandRichardWest.
5Howard(2013),3.
6Inprinciple,asecuritystruevalueisthepresentvalueofprojectedcashflowsdiscountedataratethatproperlyreflectstheuncertaintyofreceivingth
truevalueisunobservable,andestimatingitisquiteunlikeguessingthenumberofmarblesinajar.
7Surowiecki(2004),78.
8Byspecies,Imeandistinctgroupsofmarketparticipants,eachbehavinginacommonmanner.Forexample,pensionfundsmaybeconsideredone
makersathirdandhedgefundmanagersafourth.Lo(2004),23.
9SullivanandXiong(2012).
10Lane(1991),108.
11Howard(2013),3.
12Howard(2013),9.
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12Howard(2013),9.
13Forexample,HowardrecommendsthatinvestorsimplementingBPMbeawareofmarketsentimentcreatebucketsforshorttermincomeandliqu
alternativeinvestmentsandselectmanagersonthebasisoftheirstrategy,consistency,andwillingnesstotakehighconvictionpositions.Howard(201
14Black(1986),531.
15Howardassertsinpassingthatpatternsofshorttermmomentumandmeanreversiontendtobetransitoryinnature.Howard(2013),25.
16ResearchAffiliatesinvestmentprofessionalsRyanLarson(2013)andVitaliKalesnik(2013),respectively,provideclearandwellsupportedexplanat
17FamaandFrench(1988),Abstractandpages34.
18SeeKalesnik(2013).
19Theymayalsobesmarterthantheaveragebear.ThefascinatingstudyofIQandtradingbehaviorinFinlandconductedbyGrinblattetal.(2012)d
relationtoinvestmentstrategy.Nonetheless,thestudyfoundthathighIQinvestorsweremorelikelythanlowIQinvestorstohold(sell)stocksthathita
appeartobemorecontrarianthanlowIQinvestorswithrespecttothesereferenceprices.Thisisespeciallytruewhenextremepricemovementsocc
bythedispositioneffect.Citingotherstudies,Grinblattandhiscoauthorsstate,bysellingstocksatmonthlyhighsandholdingstocksatmonthlylows,h
followingarationalliquidityprovisionstrategythanapsychologicalbiasthatdiminishesreturns.(Page347.)
20QuotedinZweig(2007).
21Thaler(1999),15.BenartziandThaler(1995)madenoteofinvestorspropensitytocheckinvestmentperformancefrequentlyandattributedtheeq
myopiclossaversion.Kahneman(2011)wrote,Thecombinationoflossaversionandnarrowframingisacostlycurse.Individualinvestorscanavoid
ofbroadframingwhilealsosavingtimeandagony,byreducingthefrequencywithwhichtheycheckhowwelltheirinvestmentsaredoing.(Page339.
22Nuttin(1985),40.
23Nuttin(1985),29.
24Gjesme(1983)explainsthemeasurementissues.
25Cialdini(2009),Chapter4.
26Smith(1759),III.2.16.
27Here,too,thesocialenvironmentmattersevenwithinasinglecultureandeconomy,prevalentattitudeschangeovertime.Citingamajorstudy,Lan
theselfasefficacious,andindependenceasasourceofwellbeing,in1976thanin1957.Lane(1991),173.
28Kalesnik(2013)stated,Itisexceedinglydifficultforinvestorsandmanagersaliketoholdfastwhenthemarketcontinuestomoveagainstthem.On
investingofitsemotionalcomponentbycommittinglongtermassetstoatransparentalgorithmicrebalancingstrategy.SmartBetastrategiesarecen
transparent,nonpriceweightedsolutions.Transparencyanddispassionaterebalancingruleshelpsignificantlymitigatetheagencyproblemsfacingreg
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