How to be a true contrarian

We all like to think we're capable of defying the crowd: only dead fish, after all, go with the flow. What's more, we keep hearing that the world's famous investors go against the herd. So it's no wonder most of us would describe our investing style as contrarian, says financial blogger Jeff Macke on jeffmacke1.tumblr.com. But in fact, we're probably not.

The herding instinct is powerful: "it's impossible" not to care what people think, so it takes a pretty brave soul consistently to adopt the opposite mind-set to the majority of the population. But besides the social and emotional strain, there's another problem with contrarian investing, says Macke. It doesn't work.

To test the success rate of purist contrarianism, Macke used a sentiment gauge that stretches back to 1974. It is a CNN poll consisting of a single question "how well are things going in the country today?" with four possible answers: "very well", "fairly well", "pretty badly", and "very badly". Macke's imaginary trader made two punts every decade, always buying in at that decade's lowest ebb in sentiment and shorting at "peak happiness". After 12 months, the position would be closed.

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The results were "terrible". The "perfect contrarian" turned $1,000 into $929 over four decades, while the S&P 500 index grew that sum by a factor of 26 without reinvested dividends. "Sentimentis a lousy timing device." The hypothetical trader bought too early in 2008, shorted stocks in 1988, and "generally made a mess".

Crowds can be right

Simply thinking the opposite of what everyone else thinks, and acting on it, is clearly not enough. Sentiment can be self-reinforcing when it comes to markets, says Barry Ritholtz on ritholtz.com. Consider a football stadium: the better the team does, the louder the fans cheer, and the louder the fans cheer, the better the team does. "For most of the time, the crowd not only determines market direction, it is the market direction." So in this sense, crowds can be right much of the time, and it can prove very costly to bet against them.

Simply going against the flow at any given time is "nave contrarianism", says Ritholtz. Ideally, the true contrarian would be able to determine sentiment extremes that can herald turning points: when does the excited crowd become "an unruly mob"? But this is easier said than done.

In the late 1990s, Federal Reserve Chairman Alan Greenspan correctly pointed out that US investors had succumbed to irrational exuberance. But the market tide only turned four years later. Contrarian short-sellers of the late 1990s, thinking sentiment had already reached an extreme and must surely reverse very soon lost a lot of money.

Be a value investor

"Being a contrarian for its own sake is suicidal", says Tren Griffin on 25iq.com, but at the same time, "not being contrarian at all means that by definition you can't outperform the market". The point is to go against the herd in order to seek out value that others have overlooked and cling on to it through thick and thin. Buying shares when they are cheap has always been the best long-term strategy.

That is how the world's most successful investors made their money. Invest against the crowd not just because it is wrong, but because you know why it's wrong, as Howard Marks of Oaktree Capital Management puts it. It will then be much easier to keep your nerve when things go against you, even for years at a time.

So when people talk about contrarian investing, they usually mean value investing rather than simply going against the flow. And the fact that there are so few famous value investors, such as Warren Buffett and Neil Woodford, shows just how hard it really is for value fund managers to resist the herd instinct.

Pibs update: investors win the battle of the bonds

Investors have won an initial victory in a legal dispute with Lloyds Bank over its plans to deprive bondholders of lucrative income payments from former permanent interest bearing shares (Pibs). During Lloyds' rescue in the financial crisis, the bank swapped Pibs for bonds called enhanced capital notes (ECNs). Doing so boosted its capital base, because ECNs could be converted into shares.

Recently, Lloyds decided to redeem the bonds early because it thought it no longer needed them to count towards its capital. There were considerable sums at stake: some of the ECNs paid as much as 16% interest and were not supposed to be redeemed until 2019-2029. Around 100,000 people, including many elderly pensioners, held them. The case highlights the potential risks involved in investments in Pibs.

But the High Court has now ruled the bank cannot redeem the bonds, worth £8bn, at face value, because its grounds for cancelling the bonds were invalid. The judge found that, while the bonds were not taken into account as part of Lloyds' core capital cushion during a recent stress test, they could be in future, so they could still count towards capital.

Interestingly, Lloyds changed its story in court, initially emphasising that it didn't need the ECNs for its capital, but then saying it had made an error drafting the ECN contracts and intended something different, said fixed-income campaigner Mark Taber in The Times. Many, including the judge, "smelt a rat" in that "incredible" claim. Lloyds should now accept the verdict with good grace and drop its intended appeal.