In investing, conventional wisdom dictates that you can have either high returns or low risk, but not both. You can have either capital appreciation or capital preservation, but not both. I did not want to settle for such a suboptimal compromise.
I looked around and realized that civilization has overcome many intractable challenges with non-consensus thinking. In fact, unconventional thinking and counterintuitive concepts have resulted in groundbreaking discoveries and outsized success in science, society, sports, and Silicon Valley. So, I thought to myself, why not apply the same problem-solving approach to overcome the seemingly mutually exclusive goals of achieving higher returns and lower risk in investing? This is what I have spent a lifetime trying to do.
Contrarians refuse to give up or give in. They prefer to aim high and fail than aim low and succeed. They develop breakthrough solutions that solve for “and” instead of settling for “or.” Non-consensus investing aims for the same. Of course, as in any pathbreaking endeavor, success is never assured, but I found my mental reset got me closer to my desired destination. This chapter highlights how to secure “and” and not settle for “or”.
Power and Payoff of Non-Consensus Thinking
If you trace the origins of many major advances in human history, you will find they have come from people who challenged conventional wisdom, often in the face of ridicule and disbelief.
Centuries ago, Magellan proved the consensus wrong when he set sail and did not fall off the edge of the world, decisively proving that the Earth was round.
Edward Jenner turned prevailing wisdom on its head when he injected a cowpox virus into patients to protect them from the smallpox virus. His counterintuitive approach of inoculating the human body to prevent deadly diseases has saved more lives than the work of any other human in history.
Professor Muhammad Yunus, founder of the Grameen Bank, lifted millions of people out of poverty by making small loans to the poor without collateral, defying prevailing wisdom that only large loans to the rich secured by collateral could be profitable. His pioneering microlending program for impoverished people (especially women) started in Bangladesh, but the concept has flourished worldwide. It has become a model of success on both commercial and humanitarian grounds—twin attributes which are usually regarded as mutually exclusive. His unconventional approach to solving poverty, one of society’s most intractable problems earned him the Nobel Prize, the Presidential Medal of Freedom, and a Congressional Gold Medal.
In Canada, at the Toronto Film Festival, Piers Handling changed the business of film awards when he instituted the People’s Choice Awards. Before this, an elite jury decided who won. Their verdict provided prestige but not necessarily profits at the box office. By making the viewers also the critics, Handling ensured that critical acclaim would also signal commercial success.
Here in the United States, Oakland Athletics general manager Billy Beane transformed the business of baseball when he used statistics instead of clairvoyance to find misunderstood and mispriced talent. He proved that, with smart evaluation and trading of talent, a small payroll could still achieve outsize payoffs.1
Silicon Valley is none other than a community of contrarians, who constantly bet against the status quo and change our world forever. Steve Jobs was the poster child of this phenomenon. He transformed the mobile phone from a low-tech phone to a high-tech smartphone by upgrading the iPhone instead of dumbing it down, making the average person feel like a power user instead of a Luddite. He rejected conventional market wisdom on product design and embraced a “think different” mantra to make the iPhone an unprecedented success and Apple among the most valuable companies on Earth.
“And” Not “Or”
If you look closely at contrarians, you will find that they refuse to give up or give in. They often appear stubborn and unreasonable, but their push for change is driven by a desire to solve the intractable or to take on the impossible. To them mediocrity is a sin, if not a crime. Being the tallest among seven dwarfs is of no interest. Deep down, they are driven by the pursuit of truth or perfection, not fame or fortune. They want to change the world for the better and are not afraid to spend a lifetime doing so.
The hallmark of contrarians in fields as disparate as sports and science is that they develop breakthrough solutions that solve for the “and” proposition instead of settling for “or.” For example: Selling groceries or household necessities that are low quality or low cost is easy to do; offering merchandise that is both high quality and low cost is tough to pull off. Yet Costco, the successful U.S. retailer, has done exactly that. Making a phone that is both powerful and playful could have been an oxymoron, but the iPhone delivered both. Lending to the poor with no collateral or track record could have been a financial disaster, but Yunus proved you can do good and do well. People, products, and companies that deliver the “and” proposition are game changers and become the benchmark to beat. Those that settle for delivering “or” are soon left in the dust.
Risk or Reward?
In investing, conventional wisdom traps you into making a poor trade-off: If you want high returns, you must accept high risk; if you have a low risk appetite, you must accept low returns. I did not want to settle for this suboptimal compromise. I wanted both—high returns and low risk—so I developed a non-consensus investing discipline to improve my odds of doing exactly that.2 I have applied this investment approach since I became a portfolio manager in 1996 and regard it as the lynchpin and fountainhead of my professional success.
However, early in my career, many of my colleagues thought I was crazy to even attempt to square the circle of achieving higher returns and lower risks. My superiors were also skeptics. If you are among those, remind yourself that until Magellan, Jenner, Yunus, and Jobs proved the impossible possible, nobody believed they could pull off those feats. But here we are, flying around the world, getting vaccinated, lifting people out of poverty, and incessantly using our iPhones. While not every attempt will meet with similar success, there is a lot of truth in the old adage, nothing ventured, nothing gained.
I call my active investment approach “non-consensus investing” because the epic battle between passive and active is none other than being a contrarian. The greater the disagreement with the market, the more non-consensus your portfolio. The greater the difference versus the benchmark, the more active your portfolio. The greater the disconnect between your thinking and prevailing wisdom, the more contrarian your portfolio. Viewed from that lens, a truly active investor is implicitly, if not explicitly, a non-consensus thinker and contrarian investor.
“The epic battle between passive and active is none other than being a contrarian.”
Contrarians defy conventional wisdom by turning it on its head. Throughout this book you will see examples of how non-consensus investing does things differently if not downright counterintuitively. For instance, instead of being afraid of market volatility, it takes advantage of it. Instead of denigrating the human mind as a source of bias, it leverages its horsepower and willpower to triumph against the odds. Instead of accepting the status quo of being average and getting average returns, it upends prevailing wisdom to secure higher returns with lower risk.
Passive: lower returns and higher risk? Active: higher returns and lower risk?
In my opinion, while the need for higher returns and lower risk remains high, the ability of equities or bonds to offer either—let alone both in the next decade or so—is low.
Given today’s lofty earnings levels, stretched balance sheets, and rich valuations, I believe we are likely to experience extremely low or even negative returns in equity markets for an extended period. I am not alone in this expectation. Methods and metrics used by Nobel Prize–winning economist Robert Shiller to investment guru Buffett point to the same bleak projections (more on this in chapter 12, “North Star”).3
Also, ten-year bond yields are so low (or negative) in most markets around the world that people cannot live off interest income anymore. Worse still, many bond gurus have voiced their concerns on valuations being too rich and not offering much protection against credit or inflation risk, which means bond prices could fall instead of going up.
These are all signs that investing passively in either equity or bond markets is unlikely to yield much by way of positive returns. Not only do the return prospects look unattractive, so do the risks. Passive investing may expose you to a litany of risks that you may be overlooking. I have outlined some of them below:
“You are exposed to a litany of risks with passive investing that are being glossed over.”
1. Crowded-trade risk. The Wall Street Journal recently reported that money invested in index funds had reached 48.1 percent of all U.S. stock-fund assets as of November 30, 2018, up from 44.6 percent in the prior year, as the vast majority of flows go into passively managed index funds. Morningstar analyst Kevin McDevitt noted, “If present trends continue, index funds could exceed active funds by mid-2019.”4 Such herd behavior is symptomatic of a crowded trade, which typically sets up for inferior future performance.
2. Valuation risk. Who will buy the expensive stocks owned by passive investors when they want to sell? A wide divergence between what active investors are willing to pay (based on fundamentals) versus the price (bid up by flows) at which passives have valued their portfolios could set the stage for big markdowns, aka losses.
3. Redemption risk. If everyone rushes to exit at the same time, how will passive easily liquidate its underlying assets into cash? Who will take the other side of the trade? Will a liquid asset class turn illiquid, causing passive managers to curtail redemptions?
4. Liquidity risk. To avoid restricting redemptions, passive managers may have no choice but to dump stocks in a disorderly fashion, causing them to gap down, which I describe as the cost to exit positions. These high exit costs can be many times higher than the low entry costs, potentially making it a penny-wise, pound-foolish trade.
5. Front-running risk. Passive managers such as Vanguard and Blackrock are mammoth players, so they cannot hide or disguise their trading activities. This could make them sitting ducks for nimble traders who front run (the practice of stepping in front of large orders to gain an economic advantage). In bull markets, nobody notices or complains about front running because it pushes prices up, creating the illusion of making money. On the way down, it can turn into a house of cards, as selling begets more selling by the front runners, paving the way for larger losses.
6. Permanent-impairment-of-capital risk. Cheap beta (which is the promise of passive) is only desirable in bull markets. Passive cannot protect you against capital loss.
7. Behavioral risk. Passive is not the negation of human neuroses or biases, but the aggregation of all neuroses and biases that exist in a market.
8. Momentum risk. Lacking self-correcting mechanisms, indices can swing wildly from greed to fear as momentum cuts both ways. On the way up, it turbocharges returns; on the way down, it turns into a vicious downward spiral. Such roller coasters can be nerve-wracking, and investors may feel compelled to redeem instead of riding it out, exposing them to many of the risks described previously.
9. Reflexivity risk. If you think that passive is unemotional, objective, and rational, think again. Going passive is itself an active decision. It is humans who make the decision to choose or quit passive, and they can be every bit as emotional and biased (which are accusations typically leveled against active managers).
10. Market-inefficiency risk. Because passive does not care whether a market price reflects fair value or not (and therefore the efficiency of the market itself), all of society suffers. Active investors hold managements’ feet to the fire, buying or selling specific stocks to send a signal that they agree or disagree with a business strategy. They make judgment calls about right and wrong. They do extensive work in figuring out the fair value of a business and stock. All this effort takes resources and money, but it helps society at large. To incentivize such costly and arduous efforts, markets provide rewards to active managers and their clients, making it a win-win proposition (more on this in chapter 4). Passive managers such as Blackrock and Vanguard may argue that they take proxy voting seriously and actively participate in corporate governance to ensure shareholder interests. But this pales in comparison to the ongoing dialogue and feedback that active managers can provide, including the threat of voting with their feet and selling the stock (which passive simply cannot do).
So, passively investing in equities or bonds may offer neither high returns nor low risk. This could not come at a worse time. The wealthiest societies in the developed world are aging rapidly, meaning that many people will soon start living off savings and investment income rather than monthly wage income.4
The solution is not to give up on your investment goals of securing higher returns and lowering risk, but to reconsider the means of achieving them. This book talks about those means: active investing and more specifically non-consensus investing. To be clear, my investment discipline is an intellectual framework, not some magical formula that can be readily duplicated. Its principles are classic, but their application is dynamic. The best way to understand the philosophy is by practicing it. This is why I wrote the book as a series of foundational concepts and used stock examples as case studies to illustrate them.
However, before we can understand how to practice any form of active investing, including non-consensus investing, we must understand investing itself. How is it different from speculation? How do we choose between equities and bonds? What are their risks and rewards? How is risk different from volatility? I start answering these crucial questions in the next chapter.
Top Takeaways
1. Unconventional thinking and counterintuitive concepts have resulted in groundbreaking discoveries and outsized success in science, society, sports, and Silicon Valley. I have tried to apply the same problem-solving approach to overcome the equally intractable challenges of achieving higher returns and lowering risk in investing.
2. If you trace the origins of many major advances in human history, you will find they have come from contrarians who challenged conventional wisdom.
3. The epic battle between passive and active is none other than being a contrarian. The greater the disagreement with the market, the more non-consensus your portfolio. The greater the difference versus the benchmark, the more active your portfolio. The greater the disconnect between your thinking and prevailing wisdom, the more contrarian your portfolio.
4. In investing, conventional wisdom has dictated that you can have either high returns or low risk, but not both. I refused to settle for “or” and developed an investing framework to improve my odds of achieving both: higher returns and lower risk.
5. Over the next decade or so, passive may offer neither high returns nor low risk. The solution is not to give up on your investment goals, but to reconsider the means of achieving them. This book talks about those means: non-consensus investing.