Contrarians Everywhere, Contrarians Nowhere

A brief comment on the inescapable psychological effects of variance

Bill Brewster had the author of the Raging Bull newsletter on his podcast and they talked generally about small cap value ideas. You can listen to the full episode to get the actual names.

But I thought the most interesting part of the podcast was a brief discussion about fund manager incentives that shape returns - and the way those incentives make it difficult for managers to stick with these deep value ideas. I will try to frame the basic problem as follows:

1. Returns have to come from knowledge which is off-consensus.

2. If the knowledge was already consensus then the price would offer little opportunity.

3. So contrarianism is required to generate returns.

4. It’s very easy to want to be a contrarian.

5. It’s very hard to actually be one.

6. If it were easy, then we wouldn’t have all of the crowding into the consensus ideas in the first place.

For a fund manager this problem becomes particularly acute as it relates to raising, and maintaining, outside money. Dylan said in the podcast that he hopes his Limited Partners (“LPs”) will have sufficient tolerance for sticking with these off-consensus ideas.

This is a very optimistic view.

I can think of a few different ways to describe why it’s so hard to convince people of off-trend ideas, but I think the best example is also the stupidest example.

If you walk up to a roulette table in Las Vegas, and the board shows that the last 10 spins have all been red, you will see that humans cannot resist betting red again. You could try to explain to them about natural variance, and how the house edge in roulette works, and you will get blank stares.

So they will bet red again¹.

I say that’s the stupidest example, but the underlying psychological mechanism is everywhere if you pay attention.

We are nearly incapable of being able to separate out what is true, from what we’ve recently seen.

Let’s get back to the issue of a fund LP. What does an LP know about the fund they’re invested in? Do they really know anything about the underlying process? I mean they can listen to it being described. Is that knowledge? Considering that they couldn’t replicate the strategy, it’s probably not real knowledge.

The LP “knows” the strategy almost in the same way I know that Christian Laettner didn’t miss in the 1992 Regional Final against Kentucky. It’s sort of trivia.

Their choice to invest isn’t that different than the person sitting at a roulette table. They see a sequence of good returns, and they pull the trigger. Which is completely fine as long as the fund keeps generating returns.

But when it doesn’t, will that LP have the stomach to stick with it?

Keep in mind they have gone from this situation:

1. Idea sounds bad.

2. Results are good.

To this situation:

1. Idea sounds bad.

2. Results are bad.

I don’t actually care that much about the problem that fund managers or LPs have when it comes to dealing with consensus ideas, or natural variance. I am not a fund manager, or an LP.

But this underlying psychology has a lot of relevance even for retail investors, for two main reasons.

1. Your idea needs to be off-consensus when you enter the position.

2. It has to become consensus at some point if you want to get paid.

And so, if you want to actually get involved in stuff that pays off, and you don’t want to be a bagholder - crying about how the world doesn’t understand how good your idea is - then eventually you need those people who were standing in line at the roulette table… the people who couldn’t believe their good fortune of being able to bet a sure fire winner like red (for the 11th time).

So the question: “How does this idea eventually become consensus?” turns out to be a pretty important one.

Human psychology is, at once, the most fun and frustrating part about doing anything where variance exists. That’s all for now but I have some more adjacent thoughts for a future post.

1. For this example to have its intended properties we will assume that this is a fair roulette wheel, so that the person on the side of “this is all just variance” is actually right. Of course not every roulette wheel is fair. Some very small percent of the time the roulette wheel has a bias. Then the folks slamming red 16 on every spin are the geniuses. Insert midwit meme here.