The Contrarian Concept: Why Go against the Market?

The value of contrarian investing is anything but settled science. It is controversial. If you believe that the market's conventional wisdom is often wrong, then contrarian strategies will be appealing and potentially more profitable than following the crowd beliefs. History, whether of market activity or science, has demonstrated that the consensus is easily wrong more than right. So a contrarian relies on the tendency of the majority to time entry and exit poorly, and for that same majority to follow rather than to lead.

Within the market, contrarian investing and trading is a popular approach but it is not always easy to apply.

When prices of a stock are rising rapidly, it is difficult to resist the temptation to jump in and take advantage of the trend. When prices are falling, it is equally difficult to resist the temptation to get out before prices fall even more.

Key Point

The hardest part of the contrarian strategy is having the discipline to go against what the majority thinks.

As a contrarian, you need to put aside the emotional and natural impulses to act in the same manner as everyone else, and to be willing to sell when prices have risen too quickly or buy when prices have declined and when everyone else is fearful.

This is counterintuitive to the way that most people naturally think and act. This is due to what most people perceive about how to act either individually or collectively. As social beings, people know that collective action is powerful and convincing. This has both positive and negative aspects for investors and traders. If the crowd psychology of the market is to believe that a company is going to grow rapidly, then the collective demand for stock will drive up prices. But how far will that go? If you are one of the early believers in this supply-and-demand trend, then you can profit well from taking up positions. However, at some point the crowd psychology can convert into a more mindless form and revert to mob mentality. In this phase, people are likely to act irrationally and take comfort in the collective action itself rather than analyzing the opportunity rationally and logically.

Investors and traders have to overcome crowd psychology in order to act and behave as a contrarian, and it is against human nature to do so. Sigmund Freud wrote that people acting within a crowd majority tend to act differently toward people thinking outside of the crowd's belief. In other words, a majority does not easily accept contradiction offered by individuals. Most people instinctively want to be accepted as part of the crowd, or 'tribe' of people thinking alike, in the belief that the collective belief provides safety and protection. However, contrarians are aware that as a crowd's beliefs are made uniform, each individual within the crowd is likely to become less aware of their actions as individuals. It gets easier to go along with the majority.

Whether a crowd becomes a mindless mob with an anonymous and comforting personality, or is simply a group of like-minded individuals, is controversial. No one can identify conclusively why crowds act as they do, but the tendency is a reality. For anyone acting as a contrarian, the most difficult aspect is ignoring the desire to be a part of the crowd.

Key Point

It is human nature to want to be accepted, which is why most people cannot successfully apply contrarian theories to their timing.
The issue is complex. Under the belief of convergence theory, crowd behavior is not an automatic response of crowd thinking, but is created by individuals who bring the thinking into the crowd. This 'contagion' grows from a crowd of like-minded people. This makes a certain degree of sense when applied to markets. For example, when several people are prone to believe that a particular stock is likely to increase in value, one influential individual acts by buying stock, and is imitated by others who share the point of view. They converge into thinking in the same manner.

In convergence theory, an individual who buys or sells shares of stock may influence others based on a shared belief in the conditions of the market, inherent risks or opportunities, or the tendency to go along with people in similar circumstances. So in a work or social setting, a respected investor or trader can hold a great deal of influence over his or her peers and when that individual makes entry or exit decisions, the convergence of thought may easily lead to a duplication of the action.

A contrarian, however, recognizes convergence theory and resists it. The recognition of the tendency gives a contrarian great power, because that contrarian has insight not only into the crowd's mentality to act together, but into why the crowd does so.

Putting this another way, a contrarian recognizes how crowd behavior works as a predictable force in the market and is able to exploit it. The convergence of many individuals creates price movement in the market that inevitably creates mispricing. So when there is good news, the price is driven too high and has to correct in subsequent sessions, and on bad news, the crowd drives price lower than the news justifies, meaning the price corrects in the following sessions. This endless overreaction of price is the key to successful swing trading, but it also points to the short-term advantages that all contrarian traders and investors hold. By not going along with the crowd thinking, they are able to recognize overreaction and act accordingly.

Key Point

Contrarians tend to be astute observers of human behavior, and are able to recognize moments when the majority belief is likely to be wrong.

This applies not only to the very short-term price swings that occur on a daily basis, but also to longer-term trends. A general belief in a company's potential for growth may lead to exaggerated price appreciation (reflected in the P/E ratio rising quickly, for example), and the same kind of crowd-based belief that a company is not a sound investment may easily depress its stock's value. Both of these conditions create opportunities for contrarian investors.

Contrarians may act on their observations about price movement by buying depressed stock, short-selling stock that is overpriced, or using options on either side to exploit the very short-term price swings that may occur. For long-term investing, the use of price declines to oversold conditions can be used to identify a bargain price level and to buy shares in carefully selected companies. This is a strategy used by value investors. The concept requires prequalifying a company based on a few sound fundamental principles, and then seeking a bargain price as the entry point.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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