Smart Investors Go Against Herd

"No one believes children," snarls Jim Carrey, curling his lip as the menacing Count Olaf in the movie "Lemony Snicket's A Series of Unfortunate Events."

That statement perfectly parallels the life of the contrarian investor (search), who often is scorned within the financial community because he or she speaks up and opposes the prevailing wisdom. Both children and contrarians know the frustration of being right but having no one believe them, as well as what it's like to hang onto that belief in the face of skepticism, mistrust and even ridicule.

The common curse of child and contrarian is that no one believes either one until it's too late. For contrarians, that's because most people change their beliefs about the markets only in hindsight — and only after the market itself has already changed. Vindication for contrarian investors comes when they are proved right, when the markets turn in the direction they have predicted —opposite to what the herd believed.

Here's a good example: In 1998, the dotcom stock bubble (search) was in its heyday. Everyone believed that Internet stocks were the Promised Land and that any other kind of investment was behind the times. Then along came an investor who had worked with financier George Soros, who thought, "You know what? When everyone else sees dotcoms as the future, I believe they can't be. Something else will outlast them."

That investor was Jim Rogers, and he said that commodities were the future, when everyone else thought that commodities were hopelessly staid. The outcome? The dotcom bubble burst spectacularly, while the Rogers International Commodity Index (search) has increased 185 percent since August 1998, as reported by Business Week magazine in December 2004.

It's not so simple as being contrary for contrary's sake. Instead, it's knowing that, as often as not, conventional wisdom is wrong.

"The contrarian instinctively reacts against anything that becomes conventional wisdom," writes Richard H. Jenrette (search), one of the founders of the investment and banking firm Donaldson, Lufkin, & Jenrette, in his book, "The Contrarian Manager."

And to be a true contrarian, not only do you have to think like one, but you also must be willing to defy conventional wisdom when there is no reason to expect that the situation everyone else believes in is going to change. In short, you must grit your teeth and take action that gives other people a chance to tell you you're crazy.

So, for instance, in classic contrarian lore, you do as the German banker Meyer Rothschild (search) did. You take courage and buy stocks in a time of panic or chaos, or, as he put it, "when blood is running in the streets."

Or, you do as Joseph Kennedy, the famous father of President John F. Kennedy, did in October 1929. You take courage and sell all your stocks when the stock markets are at an all-time high. Why? Because the fellow who shines your shoes outside the New York Stock Exchange starts talking up certain stocks. Kennedy got out the week before the worst stock crash in U.S. history and later wrote, "When the shoeshine boy starts giving you tips, it's time to be out of the market."

More recently, suppose you had sold crude oil a few months ago, knowing that winter was on its way – a time when oil prices usually head up. That would have been a classic contrarian move. And, as it turns out, a move that would have been smart, since crude oil topped at $55 in October 2004.

Right now, the overarching belief is that U.S. stocks are in a bull market for the foreseeable future. It's been going on so long – since the early 1980s – that it predates those who are in their late 30s or younger. So, Generation Xers haven't lived through a bear market the way others have, which makes it difficult for them to even imagine one.

Regardless of age and experience, though, no one wants to see the bull market end, especially not the Baby Boomers. After all, the buy-and-hold strategy has worked beautifully for decades. Why change now?

Rather, people prefer to believe in the fantasy that we've entered a new era in which stock markets trend in just one direction. Contrarians, however, know the danger of this kind of complacency. When everyone agrees that something is so, that's when they start railing, "No, it isn't, wake up!"

But even when events vindicate contrarians, they're doomed to become pariahs again as soon as they take their next contrarian view.

So why do it? Why be the voice in the wilderness that forecasts a bear market when everyone else says the bull is here to stay or a bull market when every one else says the bear is here for a while?

Bob Prechter, founder of Elliott Wave International, answers that question in the foreword to his book, "Conquer the Crash," in which he predicts a deflationary depression: "The reason I remain willing to express my unconventional view is that I believe that my ideas of finance and macroeconomics are correct, and the conventional ones are wrong."

You can't get more steadfastly contrarian than that.

Contrarians are never the most popular people. They can even be sort of irritating in their dogged dismissal of conventional wisdom. But the truth is that they often are right, and they often sense a change coming well before investors who are too busy following the crowd.

As Jenrette writes:

"I long ago concluded I was best as a contrarian investor, as contrasted to someone good at spotting a trend well after it got under way and riding it to new heights. I was always at my best when 'the end of the world seems nigh,' such as in 1974 and again in 1980, when interest rates soared to double-digit levels and the markets collapsed, or again when the stock market collapsed in 1987. The collapse of the real estate markets in the early 1990s also created some extraordinary buying opportunities for contrarian-minded investors."

In other words, Jenrette was good at (and probably still is good at) buying when blood is running in the streets. When the stock market collapsed in 1987, it took real courage to decide to get back in and start buying. Everyone on the Street believed and all the financial reporting and conventional wisdom pointed in one direction – that the market was still headed down.

On the other side of the coin, remember the late 1980s when Japan could do no wrong? Its economy was strong; its businesses were overtaking U.S. businesses; the yen was unbeatable; Japanese companies were buying prime real estate all over the world; all the press was in Japan's thrall; and quality circles and just-in-time inventorying were the hottest topics for every U.S. and European business executive. A true contrarian would have sold Japanese stocks in 1989 at the height of the Japanese love-in.

What's the next great contrarian bet going to be? In U.S. stocks? International stocks? Oil? Commodities?

Only those who can stand fast against public opinion and the herd mentality know. Watch their actions and you may know, too. Because the point is this: No one believes contrarians, but every once in a while they should. It might be a good investment – if you can take the heat.

Susan C. Walker writes for Elliott Wave International, a financial analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She received her B.A. in Classics from Stanford University.