At The Money: Contrarian Investing. (January 3, 2024)
Is contrarian investing a solid strategy, or a fool’s errand? In this episode, I speak with Michael J. Mauboussin. Head of Consilient Research at Counterpoint Global, Morgan Stanley Investment Management We discuss why it is so difficult to fight the crowd, and identify when the crowd is right and when they have gone mad.
Full transcript below.
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About Michael J. Mauboussin:
Michael Mauboussin is head of Consilient Research at Counterpoint Global, Morgan Stanley Investment Management. Previously, he was Director of Research at BlueMountain Capital, Head of Global Financial Strategies at Credit Suisse, and Chief Investment Strategist at Legg Mason Capital Management. He is the author of multiple books about investing, including The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing.
For more info, see:
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[Audio Clip]
“ You don’t need to follow me. You don’t need to follow anybody. You’ve got to think for yourselves. You’re all individuals. Yes, we’re all individuals. You’re all different. Yes, we are all different.” -Monty Python’s Life of Brian
Barry Ritholtz: Everybody wants to be a contrarian. We want to be the person who sells at the top as greed consumes the crowd or buys into the lows when the panic mob loses its mind and causes a crash.
It’s an ironic, romantic image. The swashbuckling trader besting the mob. It is very, very hard to do. I’m Barry Ritholtz, and on today’s edition of At the Money, we’re going to discuss why it’s so difficult to buck the crowd. To help us unpack all of this and what it means for your portfolio, let’s bring in Michael Mauboussin, head of conciliate research at Morgan Stanley’s Counterpoint Global Division.
He’s also the author of a somewhat infamous paper, Contrarian Investing. The psychology of going against the crowd, the perfect expert for today’s topic.
Barry Ritholtz: Let’s start with the easy question. Why is it so damn hard to fight the crowd?
Michael Mauboussin: Survival might be number one. Blame would probably be number two. But I’d say more seriously, Barry, you know, we think about asset prices and you mentioned buying, you know, buying low and selling high.
Asset prices are meant really to provide us with information. But they often influence us and that’s I think the most difficult thing for us to get around is that when things go up We naturally want to buy and when things go down We naturally want to sell and so doing something different than that is very very challenging
Barry Ritholtz: So I want to talk about market efficiency. Is it safe to say that the market? The crowd is right most of the time?
Michael Mauboussin: It probably is I think the way I think about market efficiency is really the notion of wisdom of crowds and And when our crowds smart you need three conditions diversity so heterogeneous points of view aggregation some way to bring that information together exchanges do that perfectly and And incentives, which are rewards for being right and penalties for being wrong.
So that’s the wisdom of crowds. Well, we know there’s the madness of crowds too, so how does that come about? And the answer is, when one of those three conditions are violated, and by far the most likely to be violated, is diversity. So rather than us thinking independently, we correlate our views. And so that’s, I think the biggest thing we need to think about is when are we all thinking the same way we, when are we all standing on the same side of the ship?
There’s a fascinating dimension about diversity, by the way, as a side note is you can lose diversity in a system and nothing happens, happens in ecologies as well, but just a small incremental change and all hell breaks loose. So this wisdom of crowds of Madison’s crowd is not like a straight line. It’s sort of a nonlinear function, which is really interesting and part of why it makes it so surprising and difficult for us to deal with.
Barry Ritholtz: There are evolutionary reasons why going along with the crowd is a preferred emotional setting for us cooperative primates rather than fighting against the dominant trend. Explain.
Michael Mauboussin: Well, if you think about primates and humans in particular, one of the main reasons we’ve been so successful from an evolutionary point of view is because of cooperation and cooperation means that we work together. So being part of a group is incredibly powerful and being outside the group is incredibly dangerous.
So this is something that’s. deeply rooted in how our species has evolved over time. And so that, that is a, you know, the, the ability to, to stand outside the group is actually something that’s quite difficult to do, uh, just from a fundamental evolutionary point of view.
Barry Ritholtz: And this isn’t a cultural issue. What you’re really referencing are deep seated psychological reasons for wanting to seek safety in numbers.
Michael Mauboussin: I’ll mention, Barry, one experiment, famous experiment, I think really brings this into nice focus. Um, Solomon Asch, back in the 1950s, did these experiments on conformity. And the setup was pretty simple.
He had seven people around the table, for example. Six were his, uh, were in on, in on the experiment with him. Seventh person was his subject. And he gave him a very trivial task, you know, matching lines. And they go around in controls to get it 100 percent right. And then Ash would signal to the confederates to give the wrong answer and the last person is the subject and they go around the table.
And the question is how often does the last person actually conform with something that’s obviously wrong? And the answer is a pretty high percentage of time. About three-quarters of people (Wow) at some point said something like that. And then about a third of the answers were basically conforming answers.
So that’s cool and, you know, Ash wrote this up. But if you fast forward about 50 years, Greg Burns down at Emory University did the same experiment but put people in fMRI machines. So he could peer into their brains to see what was going on as they were doing this. Now, the task he had was slightly different, but same replicated the findings.
But here’s the thing that’s so interesting – People did conform right at the same rate, roughly speaking, but for those people who remained independent, by the way, ash, 25 percent remained independent. Same thing when the burn study for those people remained independent, the part of their brain that lit up was the amygdala. That’s your fear center, right? (Fight or flight)
So for you to Stay independent. You had to overcome that sensation of fear to get to the other side, and that’s difficult for us to do. So the amygdala is actually a key ingredient in all this. And so just to say that you mentioned neurologically, there’s a barrier to us doing this because Your brain is telling you, your brain is screaming at you, don’t do this.
Barry Ritholtz: So it’s interesting we talk about fight or flight because the language around this is violent. Quote, buy when blood is in the street, fight the tape, buck the trend. What does it say about the psychology of contrarian investing that we have such violent language to describe it?
Michael Mauboussin: Well, if you just think about language, you know, we use metaphors a lot, not just in investing, but we use them in sports and so on and so forth.
And the war metaphor, which is used quite a bit actually, is all about struggle and all about conflict. And so in a sense, what we’re, what we’re saying is for you to be a contrarian, you have to overcome the struggle. You have to deal with this conflict, which is very difficult to do. So I just think that, you know, it’s a, it’s a natural mapping on this thing being so uncomfortable for all of us and a struggle for the rest of us.
Barry Ritholtz: So, so let’s talk about the organizational constraints against going against the majority, including career risk. What is it that institutionally prevents us from fighting the crowd?
Michael Mauboussin: One of my favorite ways to think about this is, uh, a distinction that I think Charlie Ellis popularized, um, founder of Grant, Greenwich luminary in our industry.
And he talked about the business versus the profession of investing. The profession’s about generating excess returns. Uh, the business is about gathering assets. And Charlie’s point was. You have a good business to have a good profession, but sometimes the business, uh, becomes dominant, right? And so an example would be when an asset class is hot or an industry is high, you start launching funds, trying to raise capital because people want that.
But you know that may not lead to the best long term results. So I think that first, that first tension, uh, ends up being a really big one. And then career risk is to your point, right? If you’re out there and you’re wrong. Even for a relatively short period of time, people are going to think you’re nuts and you risk losing your job.
And so, no one really loses their job if they’re doing what everybody else is doing, or you at least sort of lay low a little bit, and as a consequence, that reduces your career risk.
Barry Ritholtz: That, reminds me of the famous Keynes quote. Worldly wisdom teaches us it’s better for reputation to fail conventionally than to succeed unconventionally. Is this exactly what he’s getting at?
Michael Mauboussin: It’s exactly what he’s getting at. And by the way,, everyone should read this. It’s chapter 12 of, uh, of Keynes’s book. And, uh, it actually, there are a couple sentences that precede that quote that are worth, A highlighting as well. He says long-term investors who, by the way, promote the public interest, he says, will come under and will come in for the most criticism, especially if they’re being overseen by committees or managed by boards or banks, and he says, and they’re going to be viewed as eccentric.
Unconventional and rash against the average opinion. And by the way, if and when they’re wrong and they’re going to be wrong, sometimes there is no mercy whatsoever. So then he finishes without that line that flourish what you just said, which is, Hey, you know, you’re better off just conforming with everybody else’s doing because you’re not going to put yourself in line for that sort of really painful, um, exposure. Now, the flip side of that, which is obvious, is you’re not going to be able to generate the excess returns, right? So, so this is the, this is the challenge.
Barry Ritholtz: Keynes was an indexer, who knew? When the crowd is wrong, what does that suggest is going on behind the scenes when most of the thinking about a particular asset class turns out to have been, uh, facing the wrong direction. What does that really tell us?
Michael Mauboussin: There’s a line from Seth Klarman, founder of Baupost, which I love, and I think it gets to the heart of this question. Klarman says value investing, which is really all good investing, value investing is at its core the marriage of a contrarian streak and a calculator, right?
So the contrarian streak says we want to examine the other side of the issue. If everybody’s bullish, we want to see the bearish case. Everybody’s bearish. You want to see the bull’s case. But of course, being a contrarian for the sake of being a contrarian is not a good idea. Because the consensus is often right.
So, if the movie house is on fire, by all means, run out the door. Don’t run in the door, right? So this is the first thing, just to think about that. And then the second component is the calculator. And the calculator says, because everybody’s so excited, or because everybody’s so distraught, the asset prices become unduly expensive or cheap.
And the combination of those two things, I think, is where the magic lies. Now, Ben Graham wrote about this, of course. Uh, in the Intelligent Investor, he had this metaphor of Mr. Market. Buffett has repeated this, Warren Buffett’s repeated this many, many times, where Mr. Market is this person that has highs and lows and is sometimes excited and sometimes pessimistic.
And he shows up every day and says, Barry, I’m going to offer you a price. It may be way too high or way too low. And you have the option to either buy or sell or to ignore them altogether. So I think that’s a very nice way for us to think about that. The Mr. Market metaphor is, you know, sort of a quaint thing, but in many ways it captures the essence of what we’re talking about today.
Barry Ritholtz: Let’s talk about investor expectations. How do they play into the concept of contrarian investing?
Michael Mauboussin: Yeah, so the point is that From time to time, the madness of crowds takes over and people become unduly optimistic. And so we think about the dot com peak, for instance, or even recently, things like the SPAC boom and so forth, where they become unduly pessimistic.
Easy to say in retrospect, but March 2009, S&P gets to whatever is 670 (666), earnings power a lot higher, and as a consequence, expectations become unduly high, which is an opportunity for you to to sell, or they become unduly low, which is an opportunity for you to buy. And I, would just say that the main thing that, to underscore this point from the outset, to bring these, all the ideas back together, is one of the biggest mistakes people make is failing to distinguish between fundamentals and expectations. Right? And they’re separate things and they should be thought about separately.
So from time to time, expectations run way too modest. Fundamentals are much better, you should buy, and the inverse is true as well.
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Barry Ritholtz: So to wrap up, it’s very hard to fight your own emotional comfort zone and bet against the crowd. Humans evolved as a cooperative species and your gut instincts and evolutionary psychology wants to stay in the safety of the herd. Sure, it looks like there’s glory in being a contrarian. For most of us, it’s just too damn hard. I’m Barry Ritholtz, and this is Bloomberg’s At The Money.
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