The Ignorant Investor

If there is a single aspect to investing that I have yet to feel comfortable with, it is the ability to take the contrarian course.

There is nothing inherently special about being contrarian. Usually when we think of somebody as 'contrary' in nature, it isn't a compliment. A contrarian is somebody who doesn't want to do something we all want to do just because we all want to do it. As with the devil's advocate or the person who stops listening to some indie band because the band 'got commercial', the contrarian is usually someone who everyone wouldn't mind seeing run down by a runaway truck.

So I admit it, I'm not predisposed towards going against the crowd. For example, if the market has favored a particular sector long enough that I start hearing things like, "Small cap funds have murdered the S&P index funds over the past five years", the first thing that pops into my mind is that I should buy a fund investing in small cap stocks because they've done so well lately. I can't help that. That's a pavlovian response, but it's probably totally wrong.

We know that over the long term, small cap stocks and the S&P have had roughly similar returns (yes, small caps have generally outperformed the S&P, but only by a relatively small amount). So if the S&P's return for the past five years is running at 1-2%, and returns for small caps in the same period are running at 50%, what does that say about the future growth of either?

Seems like the returns on each would have to even out eventually. Either the S&P would be due for a significant jump, or the small caps would be due for a significant fall, or there'd be a combination of both movements to bring the two closer together. That's the nature of the regression to the mean. After all, I can remember a time when the S&P was murdering small cap funds in the 'olden days' before 2000. Totally killing them. And what happened then? The S&P tanked and stayed locked in a range while the small caps ran free.

Now, buying into an index that's been lagging another index is counterintuitive for us ignorant investors. That the S&P was once king of the hill isn't something we take into account. In fact, the phrase 'what have you done for us lately' springs instantly to our minds. Small caps are winners, we think. Big caps suck.

But since the market is a race that never ends, it's always worth considering whether that lagging index- be it big caps, techs, Euro-stocks- may be ripe for a good run no matter what everyone else thinks. When we buy the indexes that are out of favor, chances are we're buying them cheap. And buying cheap is always a good thing.