Why contrarian investing is a safer bet in a bear market

David Thornton

Livewire Markets

“Price dips are an opportunity to buy,” Warren Buffett famously said.

We all nod our heads and agree. If you’re a value investor, you almost have to agree by definition.

Yet, when the market sells off, retail and professional investors alike get scared that they’ll miss the chance to cut their losses. Or, on the flip side, they’ll be too scared to buy up in fear of how much further the market could fall.

We all say one thing, do another.

And so, given where we are in the cycle, I thought it would be worth reaching out to Simon Russell, co-founder of Behavioural Finance Australia.

Russell consults to fund managers and the big institutional investors about financial decision making, so he knows a thing or two about the psychological traps investors of all pedigrees fall into – especially during times of high volatility.

In this wire, you’ll hear about the main biases and mistakes that befall amateur investors at this point in the market cycle, the traps that catch out professional investors, and some strategies you can employ to make the most of the opportunity today’s market trough presents.

Misjudging uncertainty

Uncertainly can be over accounted for – both to the upside and downside. When the market is down, as it is now, investors can give too much importance to downside risk.

“Research shows that people tend to be poor at assessing the amount of uncertainty in their decisions and, as a general rule, we are over-confident.”

“To be clear, this is different from being overly optimistic. As researchers define it, being ‘overconfident’ means that whether you expect good or bad things to happen, the future is likely to be different from what you expect.”

As Russell explains, the dominant market narrative is that we are facing a period of rising interest rates, reduced consumer spending, and the possibility of recession. And with this comes the expectation of reduced corporate profitability and falling share prices.

“These threats are real; each of these things is possible, at least to some extent. However, each should be considered in light of the fact that, unfortunately, whether we are attempting to predict the timing and extent of interest rate rises, other economic variables, or broad market movements, our forecasts are highly fallible, to say the least.”

Russell offers up a great hypothetical to illustrate this point.

Imagine a situation where there’s a 20% chance of a 25% market decline (20% x 25% = 5%), and an 80% chance of a 10% annual return (80% x 10% = 8%).

The question you should then ask yourself is: ‘am I prepared to miss out on a probability-weighted 8% in order to avoid the probability-weighted 5%?’

“Perhaps in some circumstance, but making this type of trade-off is a losing game for long-term investors. Unless you are highly certain (which it’s very difficult to be) or anticipate a highly adverse outcome (which happens rarely), it’s probably best to ignore your expectations and to stay invested.”

Institutional investors aren’t immune

Uncertainty can trip up even the most seasoned investors. The problem arises when you try and predict something that itself is based on uncertainty. Interest rates and their knock-on effects are a timely example.

“Most people would probably agree that it is highly likely that interest rates will rise over the coming months – for this prediction, uncertainty is relatively low,” says Russell.

Every additional link in the causal chain from this initial premise adds uncertainty.

“Will rising interest rates reduce consumer spending? Will it reduce expenditure on consumer discretionary items, in particular? In turn, will this result in reduced revenues for the specific companies which manufacture or sell these items? And will this reduced revenue translate into these companies having a lower level of profitability?”

These kinds of causal relationships are easy to explain but are highly unlikely to bear out.

“Regardless of which chain of causal reasoning they espouse, a professional investor whose chain has many links, and who holds a high degree of confidence in their conclusions, could well be suffering from over-confidence. Unfortunately, whether the causal chain sounds plausible, whether it seems reasonable, and whether it is based on detailed analysis and facts, does not eliminate the uncertainty.”

How can investors make more reliable market predictions?

Making more reliable predictions, unsurprisingly, is as easy as eliminating uncertainty. Less specific forecasts are often more accurate forecasts.

“You could predict that interest rates will be higher by the end of the year than they are now; few would argue with this. Or you could set a wider-than-seems-necessary range into which you feel interest rates will fall by year-end," Russell says.

Such predictions may seem less insightful, but the deeper the insight the greater the chance it's unreliable. Good investing is often boring investing.

Similarly, Russell believes you should limit the number of links in your chain of causal reasoning.

“These modest predictions seem less useful than more specific ones. But more specific predictions only seem more useful because we have been misled by our over-confident sense that they are accurate,” he says.

“If you’ve created more than three links, you’re probably starting to speculate. Instead, focus on the first couple of links. You might be able to draw only a few conclusions from this limited set of more reliable forecasts, but that’s partly the point.”

Bet against fools

If everyone is making unreliable bets, then why not bet against them?

“Betting that they are over-confident in their convictions is a bet that the future will be different from what they imagine. Perhaps it won’t be quite as bad, or perhaps it will still be bad, but just different in important details," Russell says.

We don’t have to go back very far to see how betting against the prophets of doom would’ve netted the sage investor a pretty penny.

“Remember how everyone thought that the world was going to end when COVID-related lockdowns began? The important detail that was missing from these expectations was the massive fiscal and monetary response from governments around the world. Contrary to expectations, the share market boomed and the economy rebounded quickly," Russell says.

Betting against this wouldn’t have required any sophisticated analysis, but to assume that the prevailing narrative had too many unknowns.

“They just needed to know that there were many versions of reality that were ready to pop into existence – each more surprising than the last. If everyone thinks the future will be bad, for the economy, for the market, or for a specific company, those potential surprises are skewed to the upside.”

The understated power of simple investment decisions

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David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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