Human beings are susceptible to fads and "group think." If an investment seems like a sure thing, it probably isn't. That's why it behooves you to embrace "contrary investing," a method that essentially entails bucking the conventional wisdom, because the conventional wisdom is so often wrong.
Contrary investing is the art of going against the crowd -- of thinking for yourself, against the pressures of conformity. Contrary thinking works in any sort of investment market because human nature is constant everywhere. The sad fact is, most people -- and that includes investors -- are followers, not independent thinkers.
Most people move in groups. Consequently, they tend to buy after prices have already risen and sell after prices have already fallen. By following the advice of this article, you can learn to recognize the extremes of crowd behavior, and make investment plays against it.
Charles Mackay, in his 19th century classic economic book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, aptly describes the tendency of investors to behave like lemmings. Consider his account of "tulip mania":
"In 1593, no Dutchman had ever seen a tulip. Their beauty and rarity caught the national fancy. In no time, they became 'the rage' as aristocrats flaunted the exotic flowers as symbols of power and prestige...Though supplies could be increased only as fast as nature allowed, demand for tulip bulbs accelerated at a fevered pitch. Soon all tiers of Dutch society were swept up in a tulip-trading craze that peaked in the 1630s, selling 'futures' on crops not yet grown or harvested. In the end, crops of bulbs still in the ground were bought and sold so many times that the sales were called the 'Wind Trade' (as the speculative prices were being made up out of thin ai After the market crashed in 1637, bankrupting many, the era came to be known as 'Tulipmania' or 'Tulipomania.'"
In the above passage by Mackay, substitute "tulip" for "mortgage securitization," and you come to the sinking realization that nothing has changed over the last four centuries. To avoid getting sucked into similar investment fads, here are the top contrarian indicators that you should watch:
- The mainstream business press is sounding the alarm about the same trend.
Business journalists often aren't financial experts; typically they're generalists who glibly encapsulate the common consensus. For example, if the covers of major mainstream business publications are all warning of the imminent dangers of inflation, it probably means that inflation has already reached a peak and these fears are now overblown. You're better off looking at economic statistics on your own and coming to your own conclusions.
- A fundamentally strong company is unfairly getting beaten up in the press and by analysts, driving down its stock price to unjustified lows.
If a certain company is getting a lot of bad press for a misstep, sending its stock into freefall, it could be a great buying opportunity. Take a look at the company's fundamentals. If the company makes a good product that people will continue to need far into the future and its fundamentals are strong, you should consider making an investment. Bad press tends to be ephemeral. A disciplined contrarian investor is continually on the prowl for "out-of-favor" stocks.
- A fundamentally weak company is riding a wave of positive publicity.
The converse of the above rule also is true. People, with all of their irrationality, impulsiveness and emotionalism, are what move markets. A company that's benefiting from a lot of hyperbolic press coverage might have poor fundamentals and be ripe for a fall. Either avoid the stock -- or short it.
- The stock market is on an upward trajectory, fueled by euphoria.
When everyone and his brother is buying stocks and dishing out hot stock tips, it's a clear sign that a top is near. People tend to move in groups. Investors buy when they anticipate the market will rise; they sell when they anticipate the market will fall. But if everyone is expecting prices to go up, odds are that everyone who intends to buy already has bought. So, who's left to bid prices up?
- The mood of investors is bearish and gloomy.
If the stock market is bearish and everyone is treating stocks as if they were radioactive, a new bull run may be imminent. If investors are unanimously gloomy, prices can only go up.
The Madness of Crowds
Here's a quick list of notable investment "manias" that came to tears:
- The Florida real boom of the 1920s
- The stock market feeding frenzy that culminated in the 1929 crash
- The Internet/high-tech craze of the late 1990s that ended with the Dot Com Bust of 2000
- The housing/mortgage bubble that burst in 2008
In my mind, a particularly colorful (and absurd) example of the lemming-like behavior of investors is the sad tale of Pets.com, which unraveled during the Dot Com Bust. In February 2000, the company went public with an $82.5 million IPO. Nine months later, it collapsed. During its hey-day, the Amazon.com-backed company was the leading online pet store, famous for its wildly popular sock puppet spokesdog. But the company mismanaged its cash, investing in splashy and expensive TV ads instead of plowing the money back into the business.
The upshot: if you consistently buy during times of abject fear, and sell during times of euphoric greed, you'll do well.
aiPhoto: Samurai John on Flickr