Bill Gurley: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.”
Andy Rachleff elaborates on the point made by Gurley: “What most people don’t realize is if you’re right and consensus you don’t make money.” It is a bit strange that most people don’t realize this truth and yet it is common sense: you simply can’t be part of the crowd and at the same time beat the crowd, especially after fees and costs are imposed. Nobel Laureate William Sharpe famously provided the mathematical proof in a paper entitled “The Arithmetic of Active Management.” As restated by John Bogle the conclusion is: “In many areas of the market, there will be a loser for every winner so, on average, investors will get the return of that market less fees.” Of course, the part about the investors collectively getting the return of the market is key. Being a long term investor in the progress of the economy is a very good thing. As life runs its course, some investors get more of that financial return of the market than others.
A key point in all of this is that you can decide not to try to outperform a market and instead to match it as closely as you can a very low cost. Warren Buffett describes the motivation for this approach well: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
This point made by Bezos is the reason why most people follow the crowd. Michael Mauboussin explains this tendency with a simple example:
- Jeff Bezos: “You just have to remember that contrarians are usually wrong.”
“Being a contrarian for the sake of being a contrarian is not a good idea. In other words, when the movie theater’s on fire, run out the door, right? Don’t run in the door…. Successful contrarian investing isn’t about going against the grain per se, it’s about exploiting expectations gaps. If this assertion is true, it leads to an obvious question: how do these expectations gaps arise? Or, more basically, how and why are markets inefficient?”Mauboussin explains why some investments get mispriced so badly:
“Because if the crowd takes something to an extreme, either on the bullish side or the bearish side, that should show up in your disconnect between fundamentals and expectations. And that is what allows you to make a good investment… Again, the goal is not to be a contrarian just to be a contrarian, but rather to feel comfortable betting against the crowd when the gap between fundamentals and expectations warrants it. This independence is difficult because the widest gap often coincides with the strongest urge to be part of the group. Independence also incorporates the notion of objectivity—an ability to assess the odds without being swayed by outside factors. After all, prices not only inform investors, they also influence investors.”
This blog has repeatedly profiled great investors who have acquired skill in knowing when to be contrarian. Buffett’s famous admonition is: “be greedy when others are fearful and fearful when others are greedy.” One of the best times to invest is when uncertainty is the greatest and fear is the highest. This contrarian admonition is fully consistent with the Mr. Market metaphor. Make the market your servant and not your master. For example, Jeffrey Gundlach puts it this way: “I want fear. I want to buy things when people are afraid of it, not when they think it’s a gift being handed down to them.” There aren’t many people like Charlie Munger: “We have a history when things are really horrible of wading in when no one else will.”
Bucking the crowd’s viewpoint in practice in the real world is not easy since the investor is fighting social proof. Robert Cialdini: “social proof is most powerful for those who feel unfamiliar or unsure in a specific situation and who, consequently, must look outside of themselves for evidence of how best to behave there.” I discussed social proof in a recent blog post on Cialdini’s book Influence. In many cases, following the crowd (social proof) makes sense. Sticking with the warmth of the crowd is a natural instinct for most people. Many people would rather fail conventionally than succeed unconventionally. But doing the reverse is easier said that done for most people.
Andy Rachleff: “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”...