Against the Grain

Posted on: May 20, 2015 by Martin Curiel, CFA in Investments

In the early 1600s, the Dutch were introduced to a beautiful and rare flower: “the tulip." The flower became the focus of investors and speculators, and by 1637, the price of tulips had reached an all-time high. Purchasing tulip contracts seemed easy money, and the populace rushed to join the action. But even quicker than its ascent, the price of tulips crashed and thousands of people lost their fortune.

Tulip mania, as it was later characterized, illustrates the misfortune that can result from herd mentality. Both unsophisticated and sophisticated investors learned the hard lesson that there is a limit to the price of any asset class and that the feeling that “everyone is getting rich” should be a warning sign rather than a signal of a great buy. But there were some investors that went against the crowd, either by not investing in tulips or possibly even by shorting the contract (if this was possible at the time). Some of these contrarians made a fortune and likely kept it longer than those who followed the crowd originally.

We’ve experienced many bubbles since tulip mania, and likely will experience many more. The emotions of investors will bid up the price of another investment class or push it down beyond reason. As a result, the philosophy of going against the crowd will continue to be a potentially profitable trade.

When constructing portfolios for clients, we often recommend a contrarian overlay – temporary and risk-controlled bets on certain markets we feel are being overly driven by emotions. In this article, I’d like to discuss why we think this approach is a good one and some of the ways we execute it.

Bad Behavior = Opportunity

Over long periods of time, capital markets are efficient. As I have mentioned in previous articles, beating the market by “superb investment skill” is mostly a fool’s errand in the long run, one that will systematically destroy wealth for most individual investors and many institutional ones (see my past article, Killer Fees).

Over the short term, however, opportunities exist to outperform certain markets. They do so because one factor in the investment world has stood the test of time: bad investor behavior. An entire field of study exists to analyze this phenomenon. There are a few behaviors that stand out and provide the foundation for our contrarian philosophy:

  • Bandwagon Bias: People feel better when they are investing with the crowd and as part of the club. Doing something against what your friends, business school classmates, or fellow investors are doing is an extremely challenging endeavor. I live in Silicon Valley, and the thought of betting against technology is almost sacrilegious. Many of my friends believe that technology is the place to work and invest. The fact that technology stocks have risen to all-time highs (about 15%/year for the last five years at the time of this writing) encourages more buying instead of creating doubt about future growth.

  • Confirmation Bias: Investors often look for confirmation of their beliefs from friends, colleagues, the media, etc. In early 2009, when the Dow Jones hit 6,547 (at the time of this writing, it sits around 18,000, or almost three times higher than it was in 2009), most of my friends talked about the financial world coming to an end, and that capitalism was collapsing before our eyes. In the Twitter and Facebook age, the feelings of despair amplified. Many sold off their investment holdings, since it was “common sense” that the collapse was inevitable.

  • Status-Quo Bias: Human beings like to stay in their respective comfort zones and are generally resistant to change. The majority of U.S. investors, for example, have an overweight exposure to U.S. stocks relative to the world stock market. For many, it feels better to invest in companies they know well (and whose names they can pronounce) than venturing into other countries (see Not Made in the USA). This is the case despite the fact that many international markets are set to grow at high rates relative to the U.S. in the foreseeable future.

  • Overconfidence Bias: “I am a student at Harvard Business School” was cited as the most common pick-up line at a local Boston bar. It usually worked not because of the school connection, but because of the confidence displayed by the pick-up artist in question. (I’ve confirmed this with a good sample of friends who will remain nameless.) Some investors believe that because they are naturally smart, accomplished, and hard working, such factors will translate to success in the investment world. We have witnessed many examples (look up “Long Term Capital”) that demonstrate this is not the case. The correlation of education and pedigree to investment outperformance is not a strong one. Having too much confidence may work at the bar, but not necessarily inside the unforgiving financial markets.

At any point in time in one or more financial markets, we see the presence of extreme emotion and one or more of the above-mentioned biases. The situation is amplified by the unprecedented speed of information flow. Media outlets like Twitter, Facebook, and Seeking Alpha enable any news piece, rumor, or scandal to spread like wild fire. Both the emotional aspect of investing and the speed of reaction are unlikely to decelerate. As a result, markets will continue to be over-bought and over-sold, which in our view presents opportunity. Warren Buffett, likely one of the most successful contrarian investors that ever lived, once said: “Be fearful when others are greedy and greedy when others are fearful.” It is certainly easier said than done, but it is an approach that can work with discipline.

Executing a Contrarian Strategy

In our experience, success in implementing a contrarian approach is mostly a risk management exercise. Not all contrarian investments will prove successful, and so it is important to manage the downside risk of any one investment. Our framework for selecting contrarian bets involves the following:

1. Investing in broad groupings of securities

2. Identifying extreme relative return differentials

3. Having a strong investment thesis for each contrarian candidate.

Broad Groupings

Aside from the occasional gamble to feed my innate desire to speculate, I don’t believe in putting money in single stocks, bonds, or similar securities or investments. In my opinion, the idiosyncratic risks are too high to compensate for the potential return.

Using similar logic, we do not believe in finding contrarian candidates at the individual security level. Instead, our focus is to identify a diversified grouping of securities that meet our criteria.

They could include the following:

-Broad Asset Classes (e.g., stocks/bonds/cash

-Regional Groupings (e.g., U.S./International Developed/Emerging Markets)

-Countries (e.g., Brazil vs. Russia within Emerging Markets)

-Styles (e.g., Growth vs. Value, Small vs. Large Cap)

-Sectors (e.g., Energy vs. Information Technology)

Betting on a group of securities ensures some diversification relative to single investments. It is also executable from a research perspective; we cover less than 100 of these groupings. Adequately covering every single investable security in the world would be a nearly impossible task. Having a small universe of investable products also aids with performance and risk tracking.

Relative Returns

Achieving positive returns all the time in a portfolio is a pipe dream. Investing will always involve risk, which means there will be times when some investments are negative and/or underperforming other investments. This is the reason we focus on relative returns. The basic idea is that if the gap in returns between two markets is abnormally wide, then it merits further investigation and analysis.

To illustrate this concept, let us look at three recent contrarian recommendations. (Disclosure: Some of our clients – including me – hold positions in all of these. See full disclosure at the bottom of the article.)

Source:; returns annualized unless stated; through 4/30/2015. See disclosure at the end of this article.

One alternative to investing in Russia (proxy investable product: RSX) is to simply invest in all emerging markets (proxy product: SCHE). In 2015, Russia has outperformed overall emerging markets, but on a 1-, 3-, and 5-year basis, it has lagged significantly. Russia has underperformed the world markets even more. From a relative return perspective, Russia is a good contrarian candidate.

A similar pattern can be seen with Colombia (proxy product: GXG) and Silver (proxy product: SLV) in the graphs below:

Source:; returns annualized unless stated; through 4/30/2015. See disclosure at the end of this article.

Source:; returns annualized unless stated; through 4/30/2015. See disclosure at the end of this article.

Each market can be compared to a broader market. If there is significant dispersion in returns, it prompts us to consider the market in question as a contrarian candidate.

Investment Thesis

Relative underperformance is not enough reason to invest. There need to be compelling reasons why we believe that market will reverse its downward trend over the next 2–3 years. Our research involves looking at macro trends as well as how much the investor community seems to “hate” or “love” the market (the more hatred, the likelier we will invest).

The table below is a summarized view of our thinking on the three candidates previously discussed:

–Lots of negative media attention because of the Ukraine crisis
–Unpopular President that everyone in the Western world seems to dislike
–Geopolitical issues do not improve over the next few years
–Oil prices continue to decline
–Strategically located with a sophisticated human resource pool
–Improvements being made on the corruption front and relationships with the rebel groups.
-About 40% of the country’s stock market tied to energy sector
–Will likely bounce up if the U.S. stock market declines
-Demand for silver should remain steady for the foreseeable future
-Unpredictable supply/demand patterns
-Generally, much more volatile relative to other commodities, including Gold

The bottom line is that it can’t just be about the quantitative data; there needs to be a compelling case to buy into the market.

Managing Risk

At the core of all investment execution is risk management. One way we control risks is to set a limit on how much to invest in a particular market. For example, our starting stock portfolio is the world stock market by market capitalization. We typically look at the composition of two investable products, the Vanguard Total World Stock ETF (Symbol: VT) and iShares MSCI ACWI (Symbol: ACWI). At the time of this writing, the U.S. stock market made up approximately 50% of the world stock market. To execute the contrarian bet of underweighting the U.S. (it has performed extremely well relative to international markets over the last several years), we would perhaps recommend a 40–45% weight (a 5–10% underweight). If the U.S. market continues to go up, then we will underperform, but this is limited by the fact that we still have some exposure to the market.

The other important risk control is time horizon. Our contrarian bets are tactical and temporary, and we generally look to exit a bet in 2–3 years. This time period should allow for enough time to see if the investment thesis holds and to limit the potential downside.

Finally, we sometimes recommend staggering the investment funds. For example, we might set a goal of 3% of the total portfolio to be invested in a particular market, but start with 1.5% and come back in at 0.5% every few months.


Over long periods of time, fundamental factors such as cash flow, yield, and growth rates will ultimately determine an investment asset’s value, and hence the return it will provide to an investor. Over the short term, we believe that temporary dislocations in the financial marketplace do occur primarily because of emotionally driven trades. Bad investor behavior caused tulip mania in the 1600s, the tech bubble of the year 2000, the rapid descent of the Dow Jones in 2008–2009, and – some argue – the current real estate prices of the San Francisco Bay Area. Bottom line: Overreaction will continue to be a factor in driving returns of some markets. With the right analysis framework and some old-fashioned discipline, one can identify and execute an against-the-crowd trade that can yield better results than simply investing in the market or paying a manager to identify and pick individual securities. Going against the grain can often be very unpopular and take a long time to pay off, but we believe this is an attractive way to invest.

A partial list of the markets we consider can be found here:

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.