• Mark Beardow

Can we all be contrarians?

As investors we are not always rational in our portfolio decisions and behavioural factors can explain some of the "irrationality". This post discusses 2 main branches of risk preferences: "contrarian" or "trend following".

(A recent new line of interesting research has posed the question, whether there is a rational reason for "irrationality"?!)

These branches relate to other behavioural risk factors, originally documented by Daniel Kahneman and Amos Tversky in 1979 and expanded upon since.

What is meant by "contrarian"?

"To purposefully go against prevailing general market sentiment."

The fact that contrarians lean against "sentiment" suggests that they believe in the presence of the other branch of irrationality, "trend following" - which the contrarians believe causes prices to diverge from fair value.

Possible explanations for a contrarian risk preference include:

  • a response to market prices which are more volatile than economic conditions and forecasts for earnings,

  • a wholly valuation driven investment process,

  • a belief that they have information that few others possess and is not reflected in the market price,

  • a return seeking rather than risk managing mindset, and

  • a consequence of rebalancing to SAA.

However this belief can be pervasive and drive a wide range of choices which are open to investors in the formulation of an investment strategy, such as the length of investment horizon, amount of risk tolerance, and the related decisions about asset allocation and manager selection.

From our experience we have witnessed how large institutional investors tend to exhibit a contrarian nature, on average. We can cite a preference for value and mean reverting investment styles, investment decisions which are believed to be based on possessing unique information, a disciplined rebalancing approach around their long term Strategic Asset Allocations (SAA) and an agency bias where decision makers regard a contrarian nature more highly.

All of this raises some important questions:

How can everyone be contrarian?

Who are the contrarians buying and selling with?

We think institutional investors are probably less contrarian than they like to think. Obviously only a minority can be truly acting against the prevailing sentiment most of the time. Its also possible some investors are contrarian sometimes but prefer to be seen as contrarian than trend following. While there is also ample evidence of trend following, including a preference to allocate to funds and mangers which have had recent strong performance and deallocate from underperforming funds.

Recent timely research by Lo, Remorov and Chaouch examined the risk preferences of institutional investors, advisers and individuals.

The authors use a series of global surveys to determine how investors say they would react to rises and falls in equity markets. They then determine the degree of risk aversion (asymmetry to risk: fear losses more than they value gains). They found that institutional investors tend to be contrarian, advisers mostly contrarian and individuals are trend following and risk averse.

They then categorised individual investors into 5 types: passive investors, extrapolators, risk avoiders, contrarians, and optimistic investors. They defined the categories as follows "Extrapolators tend to decrease their equities allocation following bad market performance and increase it following good returns, extrapolating past trends. Passive investors leave their allocation unchanged in both scenarios. Risk avoiders cut their equities allocation substantially when they see large moves in the S&P 500 in either direction. Contrarians tend to increase their equities allocation following bad market performance and decrease it following good returns. Optimistic investors tend to increase their allocation in either scenario."

So what:

We have discussed 2 main investor risk preferences: contrarian and extrapolative / trend following, which have also been studied in recent research.

We think these investing styles can lead to wide deviations in short and long term performance, for example: compare the recent performance of FAANG equities and value oriented (low P/E) equities, which match the style of extrapolative and contrarian respectively.

We think there is a strong case to treat these preferences as risk factors and manage them as such. Our conclusion is that a diversified approach is superior than simply following one or the other.

Source: Darling Macro

References: Andrew W. Lo, Alexander Remorov, and Zied Ben Chaouch (2020), "Measuring Risk Preferences and Asset-Allocation Decisions: A Global Survey", Journal of Investment Management.

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