From the December 2013 issue of Research Magazine • Subscribe!

7 Rules for Betting Against the Herd

Don’t conform to standard thinking about contrary investing

Like it or not, you are a contrarian.

Let’s say you want buy a few shares of Facebook because, for whatever reason, you think it’s a good investment. You can feel confident that the party on the other side of the trade has a considerably different opinion than you. Optimistic about the economy? With little effort you can find dozens of convincing arguments that make a powerful case for another recession. Think the market has plenty of room to rise? A quick Internet search will turn you onto experienced and respected investors who have rational and time-tested reasons for why it will fall.

For every conclusion you have about anything, you can find well-considered, well-argued and substantive arguments that illuminate all the flaws in your thinking. There is no choice in this: Whether you do something or do nothing, you can count on the fact that there are more than a few million people who think you are wrong and are willing to put their money where their mouth is.

Most of you did not wake up this morning thinking you were contrarians. After all, isn’t a contrarian a kind of rare breed of investor; one who is willing to go against the grain of popular opinion and risk perhaps hundreds of millions of dollars of his or her money on what seems to be a risky bet—and perhaps go down in flames if proven wrong?

Isn’t Bill Ackman (down a billion dollars already on his short of Herbalife) an example of a real contrarian? Yes, of course; his short of Herbalife is a very public and extreme example of a contrarian stance, notable because of size, risk and the sensational nature of Ackman’s claims. But note that while he is taking a contrary position to investors who are long the stock, they are taking a contrary position to him. The foundation of a healthy market is laid by investors whose conclusions are contrary to each other. It is our collective differences that create the very attractive environment within which we invest.

Therefore, my fellow contrarians, our only option in this matter is to decide what kind of contrarians we are going to be. And to that end, I’d like to offer some guidelines to help you with your decision.

Contrarian Rules

1. Don’t be stupid. Charlie Munger cuts right to the chase: “It is remarkable how much long-term advantage people like us have gotten by being consistently not stupid instead of trying to be very intelligent.” Of all the mistakes I’ve made in my life, it’s the stupid ones that haunt me—because they were all avoidable. The easiest way to avoid stupid mistakes is to stress-test all decisions with a simple question at a sober moment: “What’s the worst that could happen—and could I live with that?”

Our greatest asset is also our biggest weakness—our own judgment. With just a little care and thought, just by eliminating the stupid mistakes, we can tilt the scales so that our judgment will more likely be an asset. Casinos in Las Vegas rake in billions each year just by having the odds slightly in their favor—an investment lesson all contrarians need to remember.

2. Turn off the noise. For decades I read almost all of The Wall Street Journal each day—and considerable portions of both The New York Times and The Los Angeles Times. I listened to the news on my ride to and from work, and at least a few times a week caught the national news on TV. By most common measures, I was clearly informed. But I was no wiser from it. All my wisdom came from my life experiences, my on-the-job observations, and the many books I started to read. Our job as investors is not merely to know what’s happening. We need to have appropriate context and perspective to understand the implications of what’s happening in order to make sensible choices.

3. Know thyself. You’ve been wrong in the past, so it stands to reason that you’re going to be wrong in the future. A clear sense of self-awareness is part of your contrarian arsenal. Warren Buffett tells us, “What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.” Simply by hewing to the old adage of investing only in things you understand, you’ll find yourself on the contrary side of investor behavior you always wanted to avoid.

4. Think critically. The easiest way to think critically is to find the incentives behind whatever you hear, read or see. Everyone has an agenda, and your job is to identify it. Newspapers want readers, television wants viewers, and pundits want listeners—the more drama, controversy or excitement they can find in something, the more that they will be fulfilling their incentives. They could have information worth knowing, or even valuable. Our job is to find out what’s influencing their thinking, so we can filter out their agenda. What remains is the part worth knowing.

5. Play the long game. Over the last 50 years (according to New York Stock Exchange data) the average holding period for common stocks has dropped from approximately eight years to less than one year. Wall Street research rarely concerns itself with periods longer than a year, and the media’s focus alternates between the crisis du jour and what’s working now. Money, attention, research and technology are all geared to shorter and shorter periods of time. Left out are context, perspective, patience and the lessons of history. This is the contrarian play where individual investors hold all the cards, and their advantage over Wall Street and large institutional investors is widening. The simple but critical difference between buying the stock of a business and investing in the stock market is what illuminates the chasm between buy-and-hold and buy-and-hope.

6. Prepare for the big challenge. If you invest long enough, at some point something will happen, and everything that you have learned about investing, and applied successfully for years, will stop working. If you persist, friends will question your sanity—and at some point you will begin to wonder whether the laws of logic have been suspended. This is the critical moment of investing: the juncture that pits your view of the world against everyone else—and you have to decide between appearing foolish or acting foolish.

7. Look in the mirror. The goal is to become contrarians by deed, not design—with one critical exception: ourselves. All investors—professional and individual, experienced and novices—are vulnerable to specific and repetitive behavioral biases that will influence us to make poor choices at the most critical times. The guidelines outlined above are designed to help us avoid the mindsets most vulnerable to these biases.

By being a conscious and vigilant contrarian to our worst behaviors we can reframe the challenge of investing and how we respond to it, irrespective of what our friends are thinking or doing. At the end of the day it is we, not our friends, who will be living with our choices—so it’s well worth the time and effort to try to make them good ones.

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