Monday, September 22, 2008

Are you a contrarian?

In investing mythology, there is a special place reserved for the contrarian investor, i.e., the investor who goes against the crowd and makes money in the process. In fact, many investors, asked to describe themselves, describe their investment style as both contrarian and long term. But are you really a contrarian investor? Last Wednesday offered a simple test. At 3.45 pm, the S&P 500 was down to about 1150, the Dow had dropped 800 points in three days and the bottom was falling out of the market. If you were watching the screen at that time, which of the following impulses did you feel?
1. Denial: This is a bad dream... I am going to wake up from it any moment... It is not happening.
2. Panic: Sell everything. The world is coming to an end.
3. Cool Assessment: Buy now. Panic yields the best opportunities.
4. Wait and see: I think I should buy, but I am too nervous. Let me wait for things to settle down a little bit.
If you were truly a contrarian, you would have chosen (3) and done something about it: tapped out your cash reserved and invested in banking stocks, for instance..... For most of us, though, denial, panic and waiting would have been more natural impulses. At the risk of revealing more about my psyche than I should be, I did not pass the contrarian test. I chose to wait and see, which in the long terms turns out to be waiting and waiting for the right moment, which either never comes or comes too late. I think, though, that there are broader lessons to be learned from this test. 
a. It is easy in the abstract to be a rational, long-term investor. It is much more difficult in practice. The same can be said about being a contrarian.
b. The fact that information is so much more easily accessible and timely has actually made the task of being a long-term investor more difficult. Twenty years ago, most of us would have been working in blissful ignorance at our regular jobs, completely unaware (at least during the day) that Wall Street was collapsing... and that may have been healthier.
c. You cannot force yourself to adopt an investment style that does not fit your make-up as a human being. Many of us are not hard-wired to be patient, long term investors, and fewer still have the stomach to go against the crowd.


Carlo Capasso said...

Dear Aswath, first of all it's a pleasure to read your blog: I search for it for a long time (I didn't know you never ad it). As I'm pleasured I'm sure it will be a success.

By the way, I made the "contrarian test" and I choose "wait and see"too, so I didn't pass the test.
I think my choice would be the same even if simulating operations with "trading paper".

I think the U.S. situation (Bush confirmed it) would affect the choices of most of us that probably, in these days, would be "sell everything" to close all positions.

Kind Regard from Naples (Italy)

Justin said...

Interesting thoughts on this and I'd like to see this expanded upon. This 'test' was done in hindsight. I fell into the wait and see, but I also think the market is going lower in the next 12 months so I didn't want to be early in taking a contrarian position.

John L. said...

Prof Damodaran,

In the abstract, human beings are all subject to (1) group think (2) obedience to authority (3) naive realism (4) confirmation bias, and a slew of more psychological problems.

Every human being has an amygdula, that evokes feelings of fear...The hippocampus takes care of making us react negatively when stock prices fall, and to take a longer time to recover from the "shock" of losing a quotational loss of equity. People who want to dig deeper into this subject can read about the limbic system in wikipedia.

I say all this because I want to assert that contrarianism is a verb, not a noun. True, it is possible to make contrarian bets every once in a while (as a consequence of impeccably unassailable research) but one can never be a contrarian. No human being is capable of that feat, and we should thank the limbic system for that.

Technovestor said...

The part I like is that 'we are not hard-wired to be contrarian'..... It is true. But slowly and surely, by practice, we can better our selves and try to do our bit.. I have been very impulsive in trading, and fairly unsuccessful at that ;). However, picking up some stocks when I feel it is undervalued and holding on, has paid off, Everyday I fight against my impulses to be patient, and hold on to my tech stocks.

Justin said...

I also wanted to get your thoughts on how time impacts a contrarian view. Obviously if you would have taken that investment strategy; you would have been wrong to do so as today showed.