For a contrarian investor (and we are talking about a portfolio of stocks here rather than an individual stock) the typical response is somewhere between options two and three. Continue to analyse the opportunity set and as it becomes ever more attractive to do so, skew the portfolio more towards the cheapest stocks. However, it is probably best not to come over as too pig-headed, bloody-minded or unprepared to investigate alternative views. "The market is obviously wrong" rarely wins plaudits with clients on the receiving end of one’s under-performance.
The psychologist will tell you at these times that to remain rational, one should actively search for those whose views oppose yourself. Continually seeking solace from like-minded individuals can quickly encourage ‘confirmation bias’ – the belief that something must be right because someone else agrees with you. Clearly it is healthy to search for contrasting views, but at such times the opposition have the upper hand – they are supported by a good narrative to which a trending share price brings further validation. The contrarian, on the other hand, appears to have just conjecture: "What if it the story reverses even though there is no sign of it?" or history: "something typically turns up, the market is just not always smart enough to see it."
It is not that the psychologists are wrong – it is more that when markets or stocks are at extreme levels, there is probably not a great deal of rationality on either side. Someone who sold a stock a lot higher is busy patting themselves on the back and telling their war story rather than considering whether the price has gone too far or the facts have changed.
Whereas someone who purchased a stock on the way down only to lose a reasonable amount of money is busy licking their wounds, reluctant to add to a position and worried that the market knows something they do not. In these cases it is often good to return to analysis conducted in quieter, more rational times. The popular view may be well made, but at a lower price and valuation, what odds are being received for taking the contra view?
Underperformance is never nice, but for investors with high conviction portfolios and/or distinct investment styles it is unfortunately an almost inevitable price to pay for subsequently experiencing the good times.
Alastair Mundy is manager of Temple Bar Investment Trust and Investec UK Special Situations Fund