In 2015, research firm DALBAR published a now-famous study that showed that over the prior 30 years, while the S&P 500 earned an average of 11% per year, the average investor only achieved a paltry 2.5% return.
A one-time $10,000 investment in the S&P 500 would have been worth $232,644 after 30 years versus just $20,792 for the average investor. That’s a hell of a difference.
Why is the spread so wide?
Investors get emotional. They get scared when markets fall and greedy at market peaks. Investors consistently make the wrong decisions about their portfolios when emotions take over.
I became aware of this phenomenon early in my investor education. I was fortunate to read the book Contrarian Investment Strategies by David Dreman. Contrarian investing is investing by going against the crowd when sentiment is at extremes. During points of excess greed or fear, the consensus is usually wrong.
Think about the top of the dot-com boom and the bottom of the COVID crash as examples. Markets moved violently in the opposite direction in both of those cases. During the dot-com bubble at the top of the market in 2000, investors were so greedy that doctors, lawyers, and cab drivers were quitting their jobs to trade internet stocks.
I would talk to CEOs of publicly traded companies who had no business model, no revenue, and certainly no profits or cash flow. I would ask them how they were going to keep paying their employees, and they would tell me, “You don’t understand the new paradigm.” And then their stocks would go up another 10 points that day.
It was true. I didn’t understand it. But I understood math and knew that if you run out of money, you can’t keep the lights on. As the dot-com boom continued to inflate and the companies’ financials deteriorated, I avoided nearly all of these stocks, while analysts, internet message boards, and CNBC all breathlessly cheered these garbage companies higher until the music stopped and there weren’t enough chairs.
Millions of investors lost their shirts.
During the crash in early 2020 after the pandemic shut down the global economy, investors headed for the exits quickly, only to watch from the sidelines as stocks quickly rebounded.
Investors who still bore the scars from the 2008 global financial crisis swore off the markets forever, claiming they were akin to a casino.
Meanwhile, the S&P is up 183% since the bottom of the 2020 bear market.
Twenty years ago, my career took a dramatic turn. I was hired by Avalon Research Group, the most contrarian research firm on Wall Street. We were only allowed to initiate coverage on stocks if it went against the consensus.
The firm poked lots of holes in the hype surrounding many popular stocks – so much so that the founders had to hire security after receiving death threats. How’s that for extreme sentiment?
At Avalon, we were right way more often than we were wrong.
I still go against the grain when sentiment is at an extreme. I love nothing more than buying a stock that most or all of the analysts rate a “Hold” or “Sell” or buying stock of a quality company that has been hammered after an earnings miss, despite positive results.
You can’t simply be contrarian for the sake of being contrarian. But when markets make big moves because of extreme sentiment, it’s usually profitable to take the opposite trade.
The post The Power of Contrarian Investing appeared first on Wealthy Retirement.