It’s easy to make money in the financial markets. Just do the opposite of what everyone else is doing.
That’s the rough idea behind contrarian investing. And it’s such a well-understood concept, that every one wants to be perceived as a contrarian. Your average blue-chip fund manager might simply be running a closet tracker fund, but you won’t hear them say “Oh, I just like to go along with the herd.”
There’s just one problem with being a contrarian. If no one else has terribly strong views, then you’ve nothing to be opposed to.
And that’s very much the situation we find ourselves in right now…
It’s hard to find contrarian bets right now
There was a brave attempt by Charlie Parker on Citywire earlier this week to try to find a contrarian strategy for 2010. He came up with three contrarian trades: go long sterling, sell emerging markets, and stick with cyclical stocks rather than defensives.
The first certainly seems to be a contrarian trade. And it’s one we’d have some sympathy with. The general consensus is that sterling and the UK as a whole are in trouble. This view is entirely understandable. But there’s always the possibility that a new government this year will take a hard line on fiscal policy which could boost the pound. And it also ignores the fact that most other developed economy currencies look vulnerable too. On top of this, we expect the dollar to rally this year, and sterling tends to be dragged along by the dollar.
However, British investors are likely to have a lot of exposure to sterling already. So if we were to bet on a currency rising this year, we’d rather play the dollar (against the euro, for example) than the pound (you can read more about this here: Three ways to profit as fear returns to global markets).
As for selling emerging markets or sticking with cyclical stocks – they’re interesting ideas, but I don’t feel the consensus is quite as strong on these as on sterling. Sure, the notion that China is the global leader of the future seems to now be the mainstream view. But a good number of pundits still expect China to come a cropper.
As for backing cyclicals rather than defensives, again, while many investors are arguing in favour of defensives now, there are still others who’d be quite happy to stick with the more cyclical stocks for now.
What investors should be doing
So what should we be doing? Well, when there’s no particularly strong view on where the markets are heading, perhaps the best bet is to be prepared for a wide range of potential outcomes.
That’s not the answer that most people want to hear right now. Being human beings, we investors are vulnerable to acting on our emotions and instincts, rather than on cool analysis. That’s why markets are irrational. Or at least, they don’t always do what the raw numbers suggest they should. They’re driven by decisions made by people who are as influenced by their own greed and fear as they are by rational financial considerations.
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It’s generally well understood that human beings feel the pain of a financial loss roughly twice as keenly as they appreciate gains. What’s perhaps less well understood is that a missed opportunity also feels very painful.
If you see a friend lucking out and getting into, say Barclays at the bottom of the market and talking about how he made five times his money in six months, you might be pleased for him. But you’re probably also inwardly cursing and thinking: “why didn’t I do that too?” In your head, you see the missed opportunity as a loss. You don’t consider all the dud potential trades that you avoided, that would have lost you money. You only see the one that with perfect hindsight, could have made you enough cash to retire early, buy a new car, or pay off your home loan.
This ‘opportunity remorse’ is partly how bubbles are made. People see their peers making money fast. They regret the missed opportunity, and so pile in, regardless of the fundamentals. And after a year like 2009, where stocks and just about everything else have rocketed, it’s natural for investors to wonder – where are the next big gains coming from?
However, this is a classic way to end up losing money. And as Warren Buffett says, the most important thing is to avoid losing money. It wasn’t hard to generate an above-inflation return last year. As long as you managed that, then anything else is a bonus. In 2008 on the other hand, it was very difficult to generate an above-inflation return. In fact, if you managed to avoid making a loss, then you could feel pleased with yourself. You’d also be under less pressure to take big bets in 2009 to make up for 2008 losses.
There are plenty of reasons to be nervous about 2010. From sovereign defaults to a slowdown in China to rising interest rates to rampant inflation, the global economy is vulnerable to even more potential shocks than usual.
Don’t take big bets with your portfolio – stay defensive
Given that the outlook is so uncertain, the best bet is to avoid taking big bets with your portfolio. Sticking with defensive stocks right now is hardly a contrarian bet, for example. But it makes sense to me. In a genuine economic recovery these stocks will do just fine. If the recovery doesn’t take hold, they’ll do better than cyclicals.
You can also look at individual countries, sectors and companies for stocks and regions that should do well regardless of the economic backdrop. As usual, we’ve plenty of suggestions in the next issue of MoneyWeek magazine, out on Friday. If you’re not already a subscriber, subscribe to MoneyWeek magazine.
And then, when the economic picture starts to become clearer, you’ll be in a better position to take advantage with big bold bets, rather than hoping against hope that your view of the market will turn out to be correct.
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