The wisdom of crowds, the precision of models and going contrarian

I am a contrarian by nature. That has its pluses and minuses. As a contrarian, I am constantly thinking to myself, "but, is that really true?" As a result, I often find myself recognizing a trend before it catches on or standing aside as others become enmeshed in bubble-think. Those are pretty good outcomes. But, contrarians are also the naysayers, the sceptics, the doubters. Taken too far, ‘contrarianism’ can be a real buzzkill.

The conventional wisdom is usually right

The fact of matter is that the conventional wisdom is right nine times out of ten, even ninety-nine times out of 100. So, it doesn’t really pay to be a contrarian all the time. In fact, I would argue that one is much more likely to be wrong than right as a contrarian. And that’s not a good trait for investment or analytical acumen. James Surowiecki wrote a good book called "The Wisdom of Crowds," which demonstrates how difficult it is for a individual to out-predict or outperform the collective wisdom of the masses. I definitely recommend giving the book a go.

What’s more is even if one is actually right, it doesn’t pay to be right. It pays to be right at the right time. For example, a lot of contrarians have been warning since as early as 2002 that residential property was a bubble waiting to pop. Sure, one can say, "see, I told you so. I called the housing bubble 4 years ago." But, what good does that do? Did you make any money out of that call? More likely, the contrarian prognosticator ended up losing his shirt betting against the wisdom of the crowd. Even when a contrarian is right, he can end up being a Cassandra and getting steamrolled. Bubbles can last a lot longer and prices can go much higher than your average Cassandra can withstand.

So, in short, the wisdom of the crowd is not only right nine times out ten. Even when it’s wrong, years or decades can pass before a contrarian is proven right. Just ask M. King Hubbert.

But when a contrarian is right…

But if you get your numbers and timing right, contrarianism can be a very profitable thing as we saw with George Soros, who is fabled to have made billions from predicting the crash of the Pound back in 1993. The keys are the margin of error and the luxury of time. Economics is not a precise science. Often, investment valuations are ridiculously out of kilter for years at a time before the inevitable correction brings about reversion to the mean.

One thing that irks me is the precision now applied to economics and finance. Investment banks, hedge funds and investment houses have their quant geeks churning out precise models to evaluate investment values and to evaluate risk. The problem is that the very precision these models have give false comfort to the modelers and their employers regarding both value and risk. The best example of this sense of false comfort came from the Goldman Sachs CFO when the credit markets blew up in 2007. He was quoted as saying we had just witnessed "25 standard deviation events," suggesting these were things which only happen once every million years — the models said this couldn’t happen, so it can’t happen.

Hogwash. The same thing was said in 1987 and again in 1994, when the bond markets convulsed and again in 1998 after LTCM. Your models are wrong. What these modelers fail to appreciate is the need for a margin of error, a margin of safety if you will. Ben Graham and his protege Warren Buffett popularized this approach to investing. Graham believed that one needs to invest so that if one is wrong, the margin of error in value is great enough to limit one’s losses. He says that a prudent investor invests defensively at reasonable prices in liquid assets at low leverage. On the other hand, the precision of investors’ models has caused them to take on excessive leverage for huge punts on illiquid OTC derivatives, exposing them to massive losses. We are now seeing the result.

Can you time the market?

And then there’s timing. No one can call the market, not even the best investors. Therefore, buying with a considerable margin of error and waiting for events to unfold affords one the luxury of time. While the market can be extremely volatile and unreasonable, over the long term, markets are efficient and prices tend to reflect underlying value. ‘Timing’ the market is simply buying when there is blood on the streets and the margin of error is high and selling when everyone is bidding up prices and the margin of error is low. Warren Buffett, then, is a classic market timer.

But, this means that one needs to keep a longer-term perspective and hold an investment over the long term in order to be profitable. Sometimes, that means just holding cash until things sort themselves out. This is very hard thing to do because the pressure to not miss out on a good thing is more than most of us can bear.

Conclusion

Personally, I like being a contrarian. Always curious, it’s in my nature to question the status quo. But, I am fully aware of the need to proceed with caution. Bucking the status quo by living and dying as a contrarian is likely to lead to heartache, headache, underperformance and a quick death as an investor. However, taking prudent contrarian bets only when the time is right and there is a considerable margin of safety pays off.

Is now one one of those times? Not yet.