Merging Technical and Fundamental in a Contrarian Strategy

A contrarian does not have to be strictly an investor or a trader. The two philosophies can be merged into a single contrarian strategy. A good way to understand contrarian thinking is to equate it with the tendency within the market for people to (a) act impulsively, (b) overreact to virtually all news, good and bad, and (c) follow rather than lead.

These attributes make a majority of investors and traders more likely to time their decisions poorly.

Impulsive behavior includes trading in stock based on today's news, meaning they trade at the 'exaggeration point' of the stock's price. For example, an earnings report is released and the reported earnings are far above expectations. As a result, the stock's price jumps by four points. An impulsive decision would be to buy shares right away, in the belief that the good news is only the beginning of a spectacular uptrend. However, a contrarian is going to recognize that the four-point jump is an overreaction to the good news, and that it is likely that the price will decline in coming sessions to a more realistic level, perhaps giving back half of the four-point rise.

Key Point

Reacting to news, either positive or negative, and trading as a result, means timing is likely to be poor. That news is probably already reflected in the stock's price, so the opportunity has been lost.

Overreaction to all news works in both directions. The decision to buy on good news or to sell on bad news overlooks an important fact: The news, once known to everyone, is probably already reflected in the current price and, of course, that is likely to be exaggerated. So just as buying after good news means you will probably overpay, selling just after bad news means you are giving up stock at a price that is too low and will probably rebound in the next day or two.

The tendency to follow rather than to lead is very common. Following is easier and it feels safer, but it also means that many trading decisions are going to be made at the worst possible times. It is the primary attribute of the expensive but widespread 'buy high and sell low' approach to the market.

Contrarians recognize all of these tendencies, which is why they have a more profitable experience by going against the intuitive or impulsive decisions that most people make. As a group, investors and traders tend to think that the latest trend is a permanent condition. So a stock that has lost value is always going to perform badly, and a stock that has outperformed the market is always going to perform above average. This view of the market is very common; it is also the key to contrarian success. However, to succeed as a contrarian, you have to be able to time trades in exactly the opposite direction of the majority. This means you have to move in when everyone else is fearful, and step back when everyone else is euphoric. This advice is easier to give than to follow, so contrarians are not just good at timing. They also are highly disciplined and able to set and follow rules for themselves that fly in the face of what the majority thinks.
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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