Perhaps because I recently saw a play about the band, The Kinks’ “I’m Not Like Everybody Else” comes to mind as I write this month’s Editor’s Note. Though the song, which was originally released as the B-side to the hit “Sunny Afternoon,” has nothing to do with investing, its title and chorus is a slogan investors should consider incorporating into their portfolio strategy.

True contrarian investors make a point of investing differently from everybody else. Rather than accept the consensus opinion, true contrarians ask questions and seek out factors others are ignoring, as Ken Fisher explains here. Note that this is a different behavior than what is often the stereotype of contrarian investing: being bearish when others are bullish, or being bullish when others are bearish.

Following a contrarian strategy requires asking both why an assumption should hold true as well as what other people are missing. The answers to such questions may show the consensus opinion being correct. They may also show the consensus opinion being wrong. More importantly, being contrarian means being willing to invest differently than others and having the conviction to stick with your strategy when the data and the evidence contradict what the headlines and those around you suggest.

Noted contrarian Jeremy Grantham of asset manager GMO describes financial professionals who practice this as being willing to take on “career risk.” Have no doubt, it can be a lonely world. It may cause others to ask “What are you doing?!” At the same time, when done correctly it can lead to better returns.

One reason to think differently is evidenced in the performance of mutual funds. In a new study of mutual fund returns, researchers concluded, “While we find evidence of skill in the small-cap and mid-cap sectors, we find no such evidence for large-cap funds where any significant alpha is probably due to luck and not to skill.” In other words, the researchers attribute any outperformance by managers of large-cap mutual funds to luck instead of skill. Where active managers were more likely to add skill was among mid-cap and, more particularly, small-cap stocks. See this Briefly Noted item for more about this study.

If the pros have more ability to realize better performance by looking where the crowd isn’t paying as much attention, then it stands to reason individual investors should possess the same ability. In other words, there can be a benefit (or in financial terms, “alpha”) to investing differently.

Our Model Shadow Stock Portfolio has been proof of this. Since its inception, the portfolio has gained 16.7% on an annualized basis, versus 9.3% for the Vanguard 500 Index fund (VFINX). The portfolio looks in the “shadows” of Wall Street for stocks that other investors have overlooked. These are profitable micro-cap stocks trading at low valuations. (The latest additions and new rule changes to the portfolio can be found here.)

Micro-cap stocks is one area where individual investors have an advantage. Because of the size of these companies—we restrict candidates to those whose market capitalizations are less than $300 million—many institutional investors simply cannot invest in them. Fewer eyeballs = more mispricing = greater opportunity to find bargains. In other words, to realize alpha, look where others are not.

None of this is to say that everyone should be a contrarian investor or ignore large-cap stocks. It takes a certain tolerance for risk and price volatility as well as a willingness to go against the crowd. Not everyone’s investing personality is suited for contrarian strategies, and that’s okay. There is nothing wrong with using index funds to mimic the returns of the market. But if you are willing to think and act differently without abandoning your strategy when short-term trends turn against you, there is upside to be realized by not being like everybody else.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII