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.


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.

  1. Stevie b. says

    I like your comments here very much, but also much to my surprise I find myself disagreeing with your final sentence!

    After retiring from over 30 years of involvement with discretionary portfolio management, I am still a natural contrarian. There were indeed many times when I was wrongly largely out of markets and I and my clients never regretted it one bit! Better to be a few years too early than 1 month too late! Opportunities come sooner or later and opportunities are appearing now amidst all the repetitive pessimism that's been in the actual headlines for ages & not hidden away for financial afficionados only. Nibbling areas of the UK market now makes a lot of sense given the falling £ – and that's despite the consequences for oil prices which should at least continue to fall in $ terms. Putting 1/3 of ones investible assets to work now should mean profits over the next few years at least, even if the recovery then proves to be built on sand. If I'm wrong and markets fall further without at least an interim year or 2 of recovery, there is already sufficient value to merit further investments of extra 1/3rds at progressively lower levels.

  2. Edward Harrison says

    What you are saying makes a lot of sense so I had better qualify my last statement a bit.

    That statement was aimed more at a retail investor in that I doubt a retail investor has the information necessary to navigate today’s tough investing climate.

    Do I think that stocks in general are undervalued? No. So, would I invest 70% of my assets in index funds? No.

    On the other hand, it is a bit cheeky of me to act as if there are no bargains in the stock market. There are tons. Would I buy Wells Fargo with all the financial turmoil and California exposure? Maybe. Would I buy an independent refining company like Valero? Again, I could do.

    But the average retail investor doesn’t know Burlington Northern Santa Fe from Burlington Coat Factory and would not be able to make those choices. I believe that limits options and means that the average retail investor is better off increasing income-based savings (savings accounts and CDs) at the expense of asset-based savings (401K).

    And your idea of increasing exposure to the UK makes a lot of sense. Let’s see if we hear about Warren Buffett buying companies there sometime soon.

    By the way, did you see my posts on long- and medium-term Dow returns?

    I’d love to get your reaction to those comments as well.



  3. Stevie b. says

    Edward – I too would like to clarify my comments a little. I have a pessimistic bent and things clearly look terrible – but everyone who’s anyone knows it and I hate this sort of near-universal company. I cut my teeth on Wall St. in the early 70ies. Things were pretty dire back then, but it was a trader’s market – and I don’t mean day-trades. You bought with a clear idea of how much the risk was on each trade. You bought with the idea of holding for as long as it took to make a bit and as long as the risk parameters were not violated.

    Whilst concerned by the debt-to-GDP chart, I am not convinced by the charts you mention. They tell me only that things were way out of kilter and now things are a lot less extreme. They tell me that there are times when one should admit that markets don’t make sense and one should leave them well alone. This is no longer one of those times. It’s time to start dancing, bearing in mind that it may be a slow waltz for now whilst anticipating it could be time to tango if markets go to downside extremes. I remember putting all our personal money into shares when the FT index was around 165, on the theory that the end of the world as we knew it seemed nearly nigh so losing money seemed almost inevitable whether in money or shares. I sold 3 weeks later for 100% profit. If i’d held on for another year or 2, I could have made 400%. Who cares! The profit was enough to sit back, do nothing and wait for another opportunity. That’s what any sane person should have been doing for the last few years – waiting for reality to hit before starting to dip toes into the water – and reality is indeed hitting! As I said, things look more interesting in the UK where rates at 5% have a lot more leeway to fall than the US, with Europe not far behind the UK.

  4. Edward Harrison says

    Very good comments, stevie b! I appreciate your anecdotes and contribution regarding the UK in particular.

    I also agree that now is looking like a good time for a cautious re-entry into select names and sectors.

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