A contrarian is the odd one out.

As a follow up to my previous post on contrarian investing, I’d like to explain to you why a majority of investors, both in industry and personal, undergo flawed investment strategies. These findings originated from David Dreman and his market research team, although I’m sure it has been noted by many others.

1. The story starts with human limitations. Have you ever heared that the reason phone numbers are only 7 digits long (in Canada anyway) is because that is the maximum our minds can retain? Similarly, the average person can only entertain 2-3 ideas at a time. The idea I am leading towards is human beings have a massive lack of ability in analyzing a lot of data configuraly (means analyzing data not only on their own accord, but also on how data affect each other).

2. The other side of the story has to do with a general human trait to be overoptimistic. Over 60% of drivers say they are better than average – yup! 80% of entrepreneurs believe their chances of success are over 70%, whereas survival rate in reality is about 33% after 5 years – yup! Investors are also human – yup!

So, any human being who is exposed to masses of equity data, economic data, interest rates, competitive factors, future projections and plans etc., has 0% chance of being completely right, and most often very far from estimates to even be a successful investor. What’s more is that “experts” in the industry tend to be even more optimistic and confident due to their status, but in reality analyze SOOO much information and charts and reports and tables that they are incredibly vulnerable to mistakes.

In fact, here’s a pretty self-evident survey showing the number of forecasts made by “experts” and the amount of times they performed lower in the market (it’s a little outdated, but whatever, the data still speaks for itself; modern financial models haven’t changed dramatically in the last decade). As I said, these “experts” who have tons of experience just feel like they built the ability to analyze more and more data as it comes at them through their professional demands are in fact being highly over-optimistic of their skills. Point proven:

What I took from all this research performed by Dreman is that correlations are so easy to misinterpret so decisions based on factors like beta, interest rates, future projections, economic factors, oil prices etc. should be avoided.

As humans and investors, we have to appreciate our limitations of working with mass information. Few of us can get it right (i.e. Buffett). In-depth information does NOT translate into in-depth profits in 99% of all cases; quite the contrary. Facts that are mere coincidences can seem like obvious correlations. There are NO highly predictable industries in which you can count on analyst estimates, because being exposed to so much data (and being highly overconfident), they are more likely to be wrong than even individual investors.

Overall: skip the academics. Current security analysis requires precision in estimates of earnings, cashflow, dividends etc. that is impossible to provide. Investment strategies that circumvent stumbling into these masses of data are out there. More coming in the next article!

Especially for this topic, I think a quote is in order to commence:

“The man who wants to lead the orchestra must turn his back on the crowd.” (James Crook)

I have no idea who James Crook is, but his funny observation definitely makes you think a little bit about the way the world works. To me, it’s a perfect microcosm of the investing arena, where the best in the field, such as Warren Buffett, Mark Ripple, Dave Dreman and Peter Lynch, have always advocated going against the general direction of the markets. A part of me believes that contrarian investing almost does not make sense, since who would be foolish enough to not follow the advice of these veterans? But, books keep being published about contrarian investing, in which the authors continuously claim that only a tiny proportion of investors are in fact contrarian. This reassurance keeps sparking my interest about the topic.

So, my next few posts will pertain to the basics of contrarian investing from what I have read and researched, with this first post acting as introductory.

To define, contrarian investing has been said to be closely related to value investing, in which the hunt is for equities (or other investments) that are undervalued due to lack of popularity (small countries like Ghana and Malaysia), adequate attention for proper valuation (funeral home equities), excitement (garbage collection companies) etc. This is precisely the area where a lot of contrarians have made fortunes, and these types of investing opportunities for equities are often signified by low P/E ratios, low price-to-book ratios and other similar measures. As with any good recipe, a lot of these investors simply let the cake bake long enough after finding undervalued batter, and then reel in the (fully baked) dough.

Still… an issue that used to bug me is why this type of maverick strategy is needed in the first place, and it is most likely because some mavericks believe the rest of the crowd’s strategy is somehow flawed. We’ll investigate this in the next post with some intriguing thoughts and research.

Image credit: Krystn Palmer under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 United States License.