The art of contrary thinking - Article of the week

The art of contrary thinking 

 
"Contrary” is used to denote “opposite,” or thinking opposite from the consensus view. This is not to mean telling investors to simply take an opposite view

“The contrary theory is a way of thinking, but let’s not overweigh it. It is more of an antidote to general forecasting than a system for forecasting. It is a thinking tool, not a crystal ball.”

Contrary refers to this way of thinking as a theory, probably because there had yet been little research on the relationship between human behavior and investing. The contrary way of looking at markets is the process of questioning the general opinions we hear coming from investment experts, the media, associates, friends, and family. Being contrary should cause investors to ask questions such as:

Why might the consensus opinion be wrong?

What vital issue is being ignored by markets?

Can conditions get much better or much worse?

What is already reflected in current market prices?

How is what is happening today working to change the current trend?

“Human behavior is fully as important as, if not more important than, statistical behavior.”

The average investor may not realize that a large factor in the price level and direction of markets is a function of investor sentiment. This makes sense since prices are determined by people’s beliefs about the markets and its components, such as individual stocks. It’s impossible to know what percentage of price levels and trends is a function of human psychology, but it is likely a substantial amount.

The meaning of word “art” is to say that the contrary way of thinking is not science, although many of the concepts outlined in theory are based upon human psychology.

“The ‘crowd’ is most enthusiastic and optimistic when it should be cautious and prudent; and is most fearful when it should be bold. The ‘crowd’ has always been found to be wrong when it counted most to be right.”

Why it is so important to be aware of what investors are thinking? In the investing world, people’s sentiment about a market is a direct reflection of the action they have already taken in their portfolios. The more people you hear or see who are bullish or bearish on a market, the closer we are to the maximum number of people having already taken the action that is reflected in that sentiment. Therefore, the point of maximum bullishness in a market reflects that just about everyone who could buy has already bought .. markets are always VULNERABLE for a SHAKE OUT .

The reason - if everyone has already bought, the market is unlikely to move much higher, and is likely to reverse direction. Therefore, these points of maximum euphoria or fearfulness are great times to take a position contrary to the sentiment of most investors.

Generally the traders thinking is like ,

“Well, isn’t there a seller for every buyer?

So, how could there be any time when most of the people are in or out of the market?”

The point we fail to remember is that public opinion in a speculative market is measured in dollars, not in population. One person controlling one million dollars has double the weight of five hundred people with one thousand dollars each. This is why the great body of opinion appears to be bullish at the top and bearish at the bottom. The very fact that they are long at the top shows that they have been supplied with stock from some source.”

There are many ways to gauge investor sentiment. The weekly issue of Barrons contains polls showing the percentage of bulls and bears among individuals and investment professionals. Watching business news programs will give listeners a general idea as to whether the consensus opinion is positive, neutral, or negative. The front pages of business publications and newspapers are a good source. When a particular market is front-page news, especially if the headline print size is large, it is many times an indication of overall sentiment. An amazingly good indicator of sentiment is “water cooler” talk. If you hear average people consistently talking at work or in a social setting about a market you have valuable information about what is the average person’s view.

Probably the best indicator of market sentiment is your own personal feelings. If you find yourself euphoric about your portfolio or scared to death, it’s a good bet that everyone else is feeling the same way. Investment professionals are just as susceptible to these feelings as individual investors, but the successful ones recognize that their feelings are a contrary indicator of what direction a market may take next.

So, assuming that you want to make a significant asset allocation move,

why not simply wait until a time of maximum bullishness to sell, or maximum bearishness to buy? That’s a great idea! Unfortunately, it’s not so easy to spot these moments. In addition, it’s very difficult to take the appropriate action at these times. Again, from The Art of Contrary Thinking:

We are unconsciously influenced by what is now taking place. If a boom exists, the bullish and optimistic arguments are the most popular and “acceptable.” If a slump prevails, pessimism and discouragement are contagious

People are gregarious, and intolerant and fearful of solitude. They are more sensitive to the voice of the herd (i.e., the crowd) than to any other influence. Their relations with others are dependent upon being recognized as a member of the herd. Instinctively, they follow the impulses of the herd.

A crowd thinks with its heart. A crowd never reasons, but follows its emotions; it accepts without proof what is “suggested” or “asserted.”

It takes us average humans a considerable amount of time to shift our viewpoints once we have established a given mental outlook. That is, if we have accepted a trend as moving in one direction, we are not inclined to change our outlook until well after the trend turns.

In other words, our whole psychological makeup flies in the face of being able to act contrary to the consensus opinion.

“The public is right during the trends, but wrong at both ends.”

“Frequently, opinions on a given situation will be so one-sided that the contrary opinion is obvious.

However, it may be some weeks, or months, before the trend of the situation alters sufficiently to make the contrary conclusion the correct one.”

A market’s momentum may continue to carry prices in same direction as most people expect for a period of time, creating doubt in the mind of the contrarian. It’s easy to tell when there is a lot of bullishness or bearishness, but picking the peak of that sentiment is almost impossible (unless you are very lucky), and being patient enough to benefit is emotionally difficult. To benefit from being contrary takes great patience. To be successful, an investor must be able to take a position at odds with the vastly held beliefs of the crowd, and sit with that position while the market goes in the wrong direction for an undetermined and painful amount of time.

In spite of these difficulties, there is value in contrary thinking. Asking what may be wrong with the consensus view can lead to profitable investment ideas.