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Look, then look again
When you looked at the animation in this blog, what you were actually looking at is a set of black and red pixels arranged in a pattern. However, you probably saw a horse. Then, sensing that there is more to the image, you searched for something else, and then you saw a car.
What you experienced was a simplified example of how your mind works. When the nerves in your eyes perceived the black and red dots on the screen, your mind searched its databases for a pattern that best matched the arrangement of pixels. When it found a match, you thought: ‘I see a horse!’ The process was unconscious and almost instantaneous. Knowing there was something hidden in the graphic, you kept looking at the image; your mind received more data and searched for other matching patterns. It probably took a few moments to find the second image – the car.
Our brains process what we see by recognising patterns, which can make it hard to change our first impressions.
Our mind’s pattern recognition ‘engine’ is powerful: It helps us make sense of the barrage of stimuli we receive from our senses and form helpful expectations about our environment. However, pattern recognition comes with a weakness: It makes first impressions sticky. Once you interpret what you see in a certain way, it is very hard to come up with an alternative interpretation. This is what you experienced when you looked at the black and red graphic: once you saw the horse it became much harder to match a different pattern to the same pixels.
Why is understanding how our brain processes what we see important for investing?
It is hard enough to find an alternative image in a set of pixels even when you know that you need to look for something. But what if you didn’t know there was something hidden in the graphic, or worse someone told you to look for “the horse”? You might then miss the car altogether.
This is what happens to investors. Before investors can analyse objective data about a potential investment and come up with an independent opinion of the investment’s value, they are inundated with ‘expert’ opinions of what pattern to fit to the data. In such an environment, it becomes almost impossible to look at the data with a fresh, independent eye.
Being contrarian is like looking for an alternative interpretation of an image.
Where everyone unanimously agrees they see a horse, a contrarian investor will try to look beyond this. It means being aware that there might be alternative ways to see the same investment data, and having patience and imagination to see what else might be hidden in plain sight.
All successful investments start with seeing things differently.
As my colleague Julian wrote in his recent blog post, investors compete for opportunities and each opportunity goes to the highest bidder. If the opportunity is obvious to everyone, investors who win the right to invest in the opportunity end up overpaying.
In 1903, when Henry Ford invited his lawyer, Horace Rackham, to acquire shares in the newly formed Ford Motor Company, it was far from obvious to the general public that cars would become an essential part of our daily lives and transform the way we live. Everyday life was powered by horses, tram, and rail. Automobiles existed, but they were expensive, bespoke toys for the rich. Before investing, Rackham sought advice from the president of the Michigan Savings Bank, who uttered the infamous words: ‘The horse is here to stay, but the automobile is only a novelty – a fad.’ Rackham invested $5,000 anyway and later sold his Ford stocks for $12.5 million.
In the 1920s, it became clear to everyone that cars were here to stay. Members of the expanding middle classes purchased a growing number of cars using consumer credit. There were 200 carmakers in the US alone. Investors rushed to participate in this growth, bidding up carmaker shares to dot.com-style valuations. And even though cars did become commonplace and indispensable to our lives as the investors in the 1920s expected, investors in the automobile industry didn’t come close to earning Rackham’s returns – and most lost money – because they had to pay a much higher price for the opportunity to invest.
Successful investing requires seeing things differently and looking beyond the obvious. It often means investing in unpopular companies or companies outside the spotlight, where a patient investor, willing to conduct independent analysis would see value and opportunity.