When delving on the issue that a high level of risk consciousness tends to mitigate risk, he deftly explains the progression of attitudes towards risk in a cycle and the eventual reverse. Becoming more and less risk averse at the right time is a great way to enhance investment performance. Doing it at the wrong time – like most people do – can have a terrible effect on results.
When Marks guides the reader right through the up-cycle in risk taking and the inevitable downturn that follows, the blinkers really fall off. One cannot help but clearly see how the herd mentality plainly defies simple logic.
He summarises the entire process in a nutshell:
- Over time, conditions in the real world – the economy and business – cycle from better to worse and back again.
- Investor psychology responds to these ups and downs in a highly exaggerated fashion.
- When things are going well, investors swing to excessive euphoria, under the assumption that everything’s good and can only get better. When the outlook is good and their mood is ebullient, investors take security prices to levels that greatly overstate the positives, from which a correction is inevitable. Eventually, economies, profits and asset prices can’t keep pace with investors’ ever-rising hopes.
- When things are bad, investors swing toward depression and panic, viewing everything negatively and assuming it can only get worse. When the outlook is bad and they’re depressed, investors reduce prices to levels that overstate the negatives, from which great gains are possible and the risk of further declines is limited.
The excessive nature of these swings in psychology – and thus security prices – dependably creates opportunities of over- and under-valuation. In bad times securities can often be bought at prices that understate their merits. In good times securities can be sold at prices that overstate their potential. And yet, most people are impelled to buy euphorically when the cycle drives prices up and to sell in panic when it drives prices down.
In order to be a successful contrarian, you have to do the opposite of what the herd does. And to do that, you have to diverge from the conventional cycle in attitudes toward risk.
Accepting the broad concept of contrarianism is one thing; putting it into practice is another. Going against the herd may sound savvy but requires tremendous courage. It’s not easy going against the grain and taking views that are contrary to the consensus. And it can be extremely painful when the trend is going against you.
Even more so, one must bear in mind that due to the variability of the many factors that influence markets, no tool -- not even contrarianism -- can be relied on completely.
Contrarianism isn't an approach that will make you money all of the time. Even when an excess does develop, it's important to remember that "overpriced" is incredibly different from "going down tomorrow." Markets can be over- or underpriced and stay that way -- or become more so -- for years.
To be a successful contrarian, you have to be able to:
- See what most people are doing
- Understand what’s wrong about most people’s behaviour
- Possess a strong sense for intrinsic value, which most people ignore at the extremes
- Resist the psychological pressures that make most people err, and thus
- Buy when most people are selling and sell when most people are buying
Even if you qualify on all the above points, you have to be willing to look wrong for a while. If the herd is doing the wrong thing, and if you are capable of seeing that and doing the opposite, it is still highly unlikely that the wisdom of what you do will become apparent immediately. Usually the crowd’s irrational euphoria will continue to take prices higher for a while – possibly a long while - or its excessive negativism will continue to take prices lower. The contrarian will appear wrong and look like an oddball loser.
It can be extremely painful when the trend is going against you. And if you cannot stand living with the embarrassment of being unconventional and wrong, contrarianism may not be for you. Rather than trying to do the difficult opposite of what the crowd is doing, you might have to settle for merely refusing to join in its errors. That would be a very good thing. But even that is not easy.
All the material and text in this article has been sourced from Howard Marks’ memos and his book The Most Important Thing Illuminated, unless otherwise mentioned.
