The One Problem With Contrarian Investing

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing, An Introduction into Trend Following, An Introduction into Technical Indicators, When does Trend Following Not Work, Risk Management for Trend Followers, Why Trend Following Isn’t that Useful Today, An Introduction to Contrarian Investing, Using Oscillators for Contrarian Investing, Using Magnitude Extreme vs. Time Extreme, Contrarian Investing can be Used for Different Time Frames

The beauty about contrarian investing is that you can’t go wrong. This sounds kind of scammy, like one of those get rich quick scams. But the reality is, contrarian investing is never wrong. If the crowd is going hard on in one direction, invest the other way. It’s that simple.

However, every investor (including contrarian investor) has 2 big things going against him or her:

1. Time
2. The Human Nature Factor

Reality is, extreme levels can become even more extreme. No matter how extreme a 20% decline in 3 days seems, and no matter how many reasons you have for the market to rally, the extreme can become even more extreme. Anything is possible, albeit it may be improbable. An extremely Oversold 20% decline can turn into an even more extreme 30% decline.

As we know, there are two types of investments: long positions (which are bullish bets) and short positions (bearish bets).

Contrarian Investing and Short Positions

I never ever apply contrarian investing to short positions because when it comes to shorts, there’s a time factor. Here’s an example.

Let’s say that the market has risen by 40% in 3 months. Let’s say that based on your time and magnitude extreme analysis, 40% in 3 months is considered to be Extremely Overbought. Thus you liquidate all your long holdings and go short. But because shorts have margin problems, a further 10% advance in the market will force you to liquidate your shorts. Thus, an extreme (40% advance) became more extreme (50% advance), and you were forced to liquidate your short positions at the worst time possible. Then, the market promptly crashes 60%.

In other words, you decided to short based on a contrarian decision. But because extremes can get more extreme, and because you can’t afford to wait until you’re right when shorting, this strategy lead to a 10% loss, even though you were right all along. Kind of sucks, doesn’t it?

The thing is, it’s easier for bullish extreme to become even more extreme than it is for bearish extreme to become even more extreme. Why? Because humans have a natural bullish bias. Humans (on average, including the pessimists) are more optimistic than they are pessimistic. That’s why it’s more dangerous to go short than it is to go long.

Contrarian Investing for Long Positions

Contrarian investing for long positions (as opposed to short positions) is much safer. Why? Because their is a limit to how far the market can fall ($0), but there is no limit to how far the market can rise (infinity – that’s theoretically speaking, of course).

If a market selloff goes from extreme to even more extreme, all you have to do is hold onto your long positions and wait for the market to turn around. You can’t do that with short positions – your broker will automatically liquidate your short positions at a massive loss.

The Human Nature Factor

Let’s say that the market fell by 40%, so you decide to buy stocks because an Oversold reading was shown on the Relative Strength Index. Then, the market falls another 30%. How would you feel? Well, if I were you, I’d be scared out of my wits. Human nature would panic and decide to cut loss at -30%, even though the market will probably promptly rally.

In other words, human nature goes against investment success. Do you have the courage and patience to wait until the market turns around in your favor? Or will you “chicken out” (for lack of a better word) and cut your losses at the worst time possible?

Contrarian investing is hard, because we’re all humans. When everyone else is selling, we know that we should be buying. But human nature makes us want to sell with the crowd. The opposite is also true. When everyone else is buying, we know that we should sell. But human nature makes us want to buy with the crowd, which is exactly the wrong thing to do.