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You Win By Thinking Everyone Else Is Wrong


I heard an amazing statistic earlier this year. According to Bloomberg, the 50 stocks with the lowest Wall Street analyst ratings at the end of 2011 outperformed the S&P 500 by seven percentage points in 2012. 

Think about that. Warren Buffett's goal was once to outperform the market by 10 percentage points a year. Doing the opposite of what Wall Street's smartest minds recommended last year got you two-thirds of the way there. 

As we head toward bonus season, how did finance's top analysts do this year? I dug through FactSet data on companies with the most buy and sell recommendations as of January. 

Drum roll...

Includes dividends, through December 11, 2013.

The S&P 500 is up 27.4% year to date, including dividends. So, companies with the most sell ratings in January outperformed the market by a median 25 percentage points, while those with the most buy ratings underperformed by more than seven percentage points. 

Bravo, gentlemen. 

There are two takeaways here. 

One of the most important lessons in all of finance is to understand the incentives of the guy sitting across the table from you.

It sounds crazy, but a lot of professional stock analysts aren't terribly concerned with the accuracy of their picks. "Until recently, brokerage firms did not even track the accuracy of their analysts' opinions," Stephen McClellan of The Financial Times wrote in 2009. "It is just not an important part of the analyst's job description."

Institutional Investor magazine once surveyed mutual funds, hedge funds, and other big investors -- the folks who pay for Wall Street's research -- asking what attributes are most important to them in an analyst. "Of 12 factors ranked in order of priority, stock selection placed dead last," McClellan wrote. "Industry knowledge was the key quality that institutions wanted in analysts." Individual investors hearing news of an analyst upgrade can be taken down a dangerous path without realizing this. 

But there's almost certainly something else going on here. It's the power of contrarianism. 

In 1999, at the end of the biggest bull market in history when stocks were as overvalued as they'd ever been, Merrill Lynch analysts issued 940 buy recommendations on stocks and sell ratings on just seven. Morgan Stanley had 670 buy ratings and not a single sell recommendation. Compare this with 2010, after the market crashed: Less than 30% of global stock ratings issued by Wall Street brokerage firms were buys. More than 50% were hold ratings, according to Bloomberg. 

In 2005, the investment bank Dresdner Kleinwort wrote a paper on the history of financial forecasts and found something astounding. When a composite of analyst forecasts on things like bond yields and stock prices were overlaid with what actually happened, the forecasts had an almost perfect lag. A few months after bond yields rose, analysts forecast that they would keep rising. A few months after yields fell, analysts switched their forecasts and predicted yields would continue to fall. Viewed in a chart, it was obvious what was going on: When forecasting the future, analysts were just looking at what happened in the past and drawing a straight line. "Analysts are terribly good at telling us what has just happened, but of little use in telling us what is going to happen in the future," the report said.

It's the same with stocks. Most of the companies analysts flooded with sell ratings earlier this year performed terribly last year. 

Markets will always assume tomorrow will look just like yesterday, moving as a herd toward what is often the wrong conclusion. The only way to protect yourself from this group-think is to train your brain to be allergic to popular opinions, taking contrarian views when everyone else is convinced they're right. Most people can't do that (by definition), but it's a trait you'll see in all the world's best investors. If you're uncomfortable making decisions most people around you think are wrong, don't try to beat the market. You'll never do it. 

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 


Read/Post Comments (17) | Recommend This Article (84)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 13, 2013, at 6:13 PM, Amateur2013 wrote:

    Once again Morgan is helping me stick to my own investment path and ignore the advice so blithely handed out by people who are not putting their own, real money they worked for and earned, in the market. The first thing I always ask these advisors is their track record over at least 20 years - I don't know is never the correct answer, but that is what I usually get. What other question matters when they are asking you to pay them for using your own money, and they get paid regardless of outcome because they don't guarantee results? Yet another article I will keep and forward on, thanks!

  • Report this Comment On December 13, 2013, at 9:58 PM, Somewhere wrote:

    So my big question is.... how do you find out what stocks have the most sell ratings NOW? =) They might be good candidates for the next year!

  • Report this Comment On December 14, 2013, at 10:33 AM, MartyTheCanuck wrote:

    Some of my favorite sayings

    Everybody is a contrarian.

    There is stubborness and there is confidence, be sure you know the difference.

    I really like your own quote : If you're uncomfortable making decisions most people around you think are wrong, don't try to beat the market. You'll never do it.

  • Report this Comment On December 15, 2013, at 4:17 PM, TedStriker wrote:

    Would you happen to have a reference for the Dresdner Kleinwort paper that you cite? I have the feeling that this model can be applied to other markets as well. Many thanks.

  • Report this Comment On December 16, 2013, at 3:25 PM, mtprx wrote:

    The paper is 105 pages and basically say's that if you are following a certain method that can be justified (right or wrong) you are better off than not having any excuse for your outcome. I can just imagine some wall street fund manager quoting this paper chapter and verse and being rewarded for sticking with conventional wisdom. No one wants to sustain a lose (large or small) and not have something to point at and say "I was just following these guidelines". It is far more important to note that the average holding period was 11 months! Good luck making money that way.

  • Report this Comment On December 16, 2013, at 5:34 PM, constructive wrote:

    "Thinking everyone else is wrong" is a good first step. But to "win" you also have to be right.

  • Report this Comment On December 16, 2013, at 8:08 PM, ryanalexanderson wrote:

    I believe one of the reasons the worst rated stocks did so well is that they benefit the most from a loose monetary policy. Junk bonds hit a record low in 2013, too.

    Buffett says that "Only when the tide goes out do you see who's swimming naked." The Federal reserve is holding back the tide, and promising that there will not be a low tide for years.

  • Report this Comment On December 17, 2013, at 12:50 AM, HistoricalPEGuy wrote:

    @Amateur2013 - It's true, the Fool provides a platform for someone like Morgan to advocate for reality and not just spew nonsense. There's a reason why all advisers say "past performance is not a indicator of future value". Because scientists have shown over and over again that analyst's guesses are purely luck. They are marketing. It doesn't mean they are always wrong or don't know what they are talking about. I've learned a ton from many of them. The key point is simple - they can't predict the future - use them to inform yourself, but never blindly follow their advice.

  • Report this Comment On December 17, 2013, at 1:07 AM, enginear wrote:

    If a stock has a beta above 1, and it goes down, it went down 'too much'. That's the time to buy.

    Mr. Buffett saw that 2008 was an extreme case of 'too much' going down and, as he said, he backed up the truck.

    His years of investing give him good insight, but he has another thing that's necessary: steel kahunas. Its not for the faint of heart. Easy to say, but hard to do - I pat myself on the back for sitting on my hands and not selling, but if I could have waded in and been a buyer...

  • Report this Comment On December 17, 2013, at 9:49 AM, ScoopHoop wrote:

    Some of the best advice I ever got was from George at Coney Island in Grand Island, Neb. He told me he was making money trading options in the 1990s.

    "Well maybe I should get into options?" I said.

    "Is what you are doing working for you? Are you making money and getting ahead?" he asked.

    "Yes," I said.

    "Then don't change a thing."

    That was 15 years ago. I never changed my investment style, and I've made money every year since then, except 2001-02 and 2008-09.

  • Report this Comment On December 17, 2013, at 11:31 AM, TheCommonTulip wrote:

    God, this needed to be written. It's amazing how much upgrades/downgrades move stocks. When Apple hit $450, I remember an analyst at Citi downgraded it, even though he'd upgraded it a month earlier. They're usually just trying to protect their skin.

  • Report this Comment On December 17, 2013, at 2:34 PM, Pfoolhart17 wrote:

    This message needs to be constantly reinforced, in stocks as in life. Following the crowd (a natural tendency) is a dangerous endeavor indeed--almost as dangerous as drawing a straight line from the past. There is a profound human lesson in this great article: dare to be a contrarian.

    Thank you!

  • Report this Comment On December 17, 2013, at 2:49 PM, krohleder wrote:

    I think the only way to make money is by being a contrarian. However most contrarian positions are wrong.

  • Report this Comment On December 17, 2013, at 2:56 PM, TMFJebbo wrote:

    "It sounds crazy, but a lot of professional stock analysts aren't terribly concerned with the accuracy of their picks. "

    A friend of mine who worked at Merrill Lynch told me that they NEVER discussed how much money they made for their customer, but they always talked about who brought revenue to the company. He quit.

  • Report this Comment On December 17, 2013, at 4:08 PM, ffbj wrote:

    So if we take some of the findings we could say that the part of the reason the stocks that would not do well in the future was due to the fact they had not done well in the past. So what is going down will continue to go down and vice-versa.

    So then this sets up the probability that the underperforming stocks will outperform as they have more run room to run, as they are undervalued and once again vice versa as the previously outperforming stocks are either closer to or even over their true value.

  • Report this Comment On December 17, 2013, at 4:34 PM, krohleder wrote:

    @ ffbj Yes that sounds like 'Regression toward the mean'. An investor could possible profit from that statistical anomaly. Interesting.

  • Report this Comment On December 18, 2013, at 7:51 AM, bamasaba wrote:

    And now that Apple is doing well again, it is suddenly being upgraded. Wow, those guys are so smart in hindsight!

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