Contrarian Views in Perspective

The tendency for investors and traders to go along with the crowd mentality is reinforced within the market itself. If you watch financial shows on television, you will notice a tendency to follow the trend. If the market has a huge drop in a single day, featured stories will include 'Is this the correction we have been expecting?' or 'Is this the start of a bear market?' If the market jumps several hundred points, the opposite features are likely.

Stories on topics like 'The new bull market' or 'The end of the recession' are quite likely. Financial journalism, like all forms of journalism, caters to majority thinking. With this in mind, contrarian thinkers can take a contrarian clue from the financial news programs. It may be wise to act in opposition to journalist 'expert' advice.

A cultural tendency is to go along with what most people believe. If most people think the market is going to rise, declaring yourself a bear makes you an outsider and perhaps even an oddity. The nonconformist (another word for contrarian) is shunned and even ridiculed by the majority and their spokespeople. So being a contrarian is not the easiest path, although it is often the most profitable.

Key Point

People tend to want to be accepted, so acting as a contrarian is counterintuitive. Few people seek out nonconformity as a style of behavior, although in the market it may be more profitable.

A true contrarian does not act in a contrary manner for its own sake and will not always decide against the majority. There have been many famous market experts who called markets incorrectly and lost all credibility as a result. For example, Joseph Granville was a famous market forecaster in the 1970s and 1980s. Between 1979 and 1981 his predictions in his newsletter (Granville Market Letter) were virtually perfect. But that is not what he is remembered for. In 1982, Granville predicted that the market was going to decline significantly. However, the moment of his prediction turned out to be the beginning of one of the strongest historical long-term bull markets. He remained bearish all the way to 1996.

Granville is remembered not for his amazing ability to call market trends between 1979 and 1981, but for his refusal to turn away from his bearish prediction for 15 years of mostly rising markets. This made Granville an object of ridicule despite his record of past successes. It also gave contrarian investing a black eye. If Granville was the ultimate contrarian from 1981 to 1996 by insisting a bear market was on the horizon, then contrary investing is simply a form of inflexibility.

This was not a typical contrarian story. In fact, Granville's reputation as a permanent bear even in a long-term bull market is contradicted by the principles of contrarian investing. Because he was so invested in being right about his bearish call, he refused to pay attention to subsequent signals. A true contrarian would be able to get over a poorly timed call and start fresh by analyzing the current market based on what the signs provided.

With the many attributes of contrarian investing (buying at bargain price levels or preferring to go against the majority, for example), the real meaning of the strategy is more. A contrarian does not simply defy the majority, but is analytical in how the majority thinking gets interpreted. The consensus view should always be suspect, and there is great historical precedent for this. In science, for example, many of the greatest advances have been made by individuals willing to go against the majority. A famous example is that of Galileo, who proved through observation that the earth rotated around the sun and not the other way around. The power of the day, the Church in Rome, threatened Galileo through the Inquisition because his beliefs contradicted biblical passages. Galileo was a scientific contrarian who was forced to retract his claims under threat of death and ended his life in house arrest. Yet his views were correct, even though contrary to the commonly held beliefs of the day.

The same reality applies in the market, though with less severe consequences than those Galileo faced. For investors and traders, taking on the majority is daunting. However, a successful contrarian is also likely to be more analytical and methodical than the typical investor. Most people are simply impulsive and act too quickly and on too little hard evidence. A contrarian might end up drawing the same conclusion or a different one, but the real meaning of contrary investing is not 'doing the opposite' in each and every case. Its most profound application is in the tendency to review the evidence carefully before making a trade. So it is contrary to act after studying the facts rather than to jump aboard because the majority has made a decision. Most noncontrarians will make fast decisions because they fear losing an opportunity (to get in before prices go higher or to get out before they go lower). A contrarian refuses to act quickly just because that is what almost everyone else is doing.

Key Point

History is full of examples of contrarians being shunned, and even imprisoned or worse. This bolsters the human tendency to want to remain silent and go along with the crowd.

This raises an interesting rhetorical question: If contrary investing and trading makes such sense, why isn't everyone a contrarian? This is a paradox, of course, because if everyone acted as a contrarian, it would create a new herd mentality.

There is a greater reason for most people not to act as contrarians. It comes down to the question of conformity and fear. Most people know that it is a very uncomfortable matter to act contrary to the majority and also to be proven wrong. This fear is a compelling force for most people, causing them to prefer the illusion of safety in the crowd to the potential for profitability by acting in the opposite manner. The social belief that the majority is always right is such a democratic ideal that it becomes accepted truth, even when in fact the majority is simply wrong. A contrarian in a democratic society is a minority, a troublemaker, or even an eccentric.

People also tend not to act as contrarians because they want the efficient market theory to be true. Investors and traders are continually seeking certainty in the market, even though the market by definition is very uncertain (and inefficient). If the majority acts in a particular way, it must be in response to efficiency within the market. In other words, a stock will rise or fall because the majority believes it. A contrarian recognizes that group thinking does not create (or even respond to) efficiency, but tends to disprove the efficient market theory. This is ironic because it defies logic. If there were such a thing as an efficient market, it would be a relatively easy matter to buy and sell at the right moment, because emerging trends would be obvious. Lacking this efficiency, investors and traders tend to substitute majority opinion for what they seek, and to assume that the majority opinion is in fact a reflection of market efficiency.

A contrarian approach works well for individuals, given all of the complexities of timing investment and trading decisions. The conclusion most obviously reached is that following the crowd is not a successful method for profiting in the market. Because known information is normally factored into price, reacting to what others do is a poor way to time entry and exit effectively. It is more likely to lead to ill-timed decisions.

Mixing speculation and investing within a contrarian philosophy is one of the best ways to diversify capital, with some capital left to grow in long-term value companies selected with fundamental analysis, and another portion used to play short-term price swings and based on a largely technical approach. Using both forms of analysis and diversifying between speculation and investing is the topic of Mixing Speculation and Investing.
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 2020. Content published with author's permission.

Posted in ...