Maverick Risk: Why Failing Alone is Worse than Failing Together

A maverick is an independent individual who does not go along with a group or party (courtesy of Merriam-Webster’s definition).

In general, going against "the herd" usually means stepping out of the comfort zone, thereby putting yourself on the edge. Failing alone while everyone else achieves their results is far more painful than failing when everyone is failing with you. Similarly, in the financial markets, losing money during a bull run is much worse than losing money during a recession or a crisis.

The idea of maverick risk is a compelling one. From a human behavioral standpoint, we are conditioned to think of being outside of the herd as risky. There is plenty of evolutionary logic behind this idea, considering that humans spent much of their existence as both predator and prey. There is safety in numbers.

So as much as we know the value of thinking outside the box or being contrarian, and as much as we value and revere those in society who are capable of going it alone, our lizard brains take over when it comes down to financial decisions and we seek the safety of crowds. This is true for amateurs and professionals alike and is well documented in the rapidly growing popular and academic literature on behavioral finance.

This happens due to the human tendency to focus on ex-post opportunity costs and the consequential fear of taking contrarian positions, which leads to trend chasers and positive-feedback traders. On the other hand, it has often been said that the only way to beat the market is to go against the mainstream vision and eventually be proven right.

However, in reality, not many investors consistently go against the market. Instead, it seems like there is an excessive number of trend-chasing investors. Especially in the short run, the Keynesian vision affirms that markets appear to be heavily influenced by individuals who manage capital for others, such as pension managers and investment managers. They are not exclusively driven by investment gains achieved through individual transactions or making profits. Rather, they have a somewhat different set of payoffs due to the "separation of brains and capital", which introduces a variety of factors into their equation. One element in this set is their clients' perception that they are capable.

Reputation, in fact, plays a major role for this type of investor. We have already discussed Performance-Based Arbitrage in our latest article, "Limits to Arbitrage and the 100 Dollar Bill on the Ground," which poses limits to arbitrage based on the short-term vision of portfolio managers' clients.

Due to this phenomenon, some good investment decisions, despite being anticipated, are not carried out because they may not be acceptable to the clients' eyes. The guiding principle in this environment seems to be that it is better to achieve smaller profits conventionally than to run even the smallest risk of potentially losing a lot of money unconventionally.

All this can be attributed to how we evaluate risks. Instead of focusing on absolute values, we tend to be centered on our position relative to our peers' results. Thus, every investor faces a difficult trade-off: to stay in the herd or to go against it, bearing the additional "maverick risk"?

To a certain extent, the existence of this type of risk might also explain the profitability of contrarian strategies, which incorporate a "maverick risk premium" that is demanded as compensation for the exposure to criticism.

Even though there is still academic conflict about the effectiveness of these “naïve” strategies, the overall vision is that they are profitable. But there is less accordance about the drivers of this overperformance.

The most credited theory is the overreaction hypothesis, which we will soon discuss in one of our next articles. Long story short: people tend to overreact to news, possibly leading to stock price reversals. Thus, a standard contrarian strategy shorts recent winners (companies that have recently performed well) and buys recent losers. The premise is that if the stock market overreacts to news, winners will tend to be overvalued and losers undervalued.

But what if the success of this strategy is simply a reward for the additional risk of thinking out of the box?

We typically focus on a concept of risk related to simple volatility but given our primitive tendency of staying in the herd, it might be useful to further consider the maverick risk when evaluating financial performances.