CHAPTER 1
Your Brain-Training Guide
Few truths are self-evident, but hereâs one as close as they get: In investing, the crowd is wrong much more often than right.
Most folks accept this. They remember pain from some of their own mistakes. More so, they recall market-bloodied friends, relatives, neighbors and co-workers. Theyâve seen all the famous market gurus get egg on their faces. Academic studies show the wisdom of the investing crowd is folly.
Yet folks follow along anyway. For most, itâs impossible not to! The financial blogosphere, websites and cable TV talking heads pound market groupthink into our brains 24/7. Without conditioning yourself to resist, itâs all too easy to accept repeated falsehoods as fact, melt into the crowd and buy high, sell lowâwith the rest.
There is another way! Train your brain to battle the media, the crowd, your friends, neighbors and cocktail bankers and think differently. It doesnât take vast market knowledge, a finance degree, an economics PhD or endless rigorous study. Armed with a few basic principles, internal alarm bells and an instinct for independent thought, you can be a true crowd-beating contrarian investor.
Yogi Berra once quipped, âBaseball is 90% mental, the other half is physical.â Might apply to investing! Mental discipline is key to success. See this book as your brain-training guide. Youâll learn tricks you need to protect your brain from media hyperbole and some principles to outsmart the crowd.
What does being a contrarian mean? Whatâs the secret to being right more than wrong? Prepare to find out. In this chapter, weâll start with the basics:
- Why Wall Streetâs definition of a contrarian investor is wrong
- The foolishness of conventional wisdom
- The true contrarianâs gut-check
Wall Streetâs Contrarian Contradiction
Legend lumps all investors into two categories: bulls and bears. Those who think stocks will rise, and those who think stocks will fall. If the masses are bullish, Wall Street says anyone whoâs bearish is a contrarian. If the masses are bearish, bulls are the contrarians.
But this is wrong. It implies âeveryoneââone big crowd who thinks stocks will do one thingâand âeveryone else,â another crowd thinking stocks will do the opposite. âEveryone elseâ often thinks theyâre contrarian. They think âeveryoneâ is the herd, and the herd is always dead wrong. Theyâve seen the countless academic studies showing the majority of investors are just terrible at making investment decisions, usually selling low and buying high. They believe doing the opposite of the crowd guarantees buying low and selling high.
Problem is, âeveryone elseâ is as crowd-like as âeveryone.â Their opinions usually arenât unique, and their analysis often isnât any broader or better than the main crowdâs. They look at all the same things, just with a dissenting, condescending sneer. People thinking this way and that theyâre contrarians arenât any smarter, any more discerning than you or me or the crowd. Their moves rarely pay off any better.
Thatâs the bad news. Hereâs the good news: You can be a real contrarian! Once you know what leads the crowd or both crowds astray, it isnât hard to think better and act smarter. Itâs impossible to be perfect, but to be better than most isnât so hard.
The Curmudgeonâs Conundrum
Two-herd contrarians see the world like an analog clock. They base bets on wherever the main herd expects the hand to land. If everyone says the clock will point at 1, the supposed contrarian herd bets itâll land on 7âroughly the mirror opposite direction. Just because itâs the opposite! Contrary for contraryâs sake. Much of the time, no real extra thought goes into it. Just a curmudgeonly instinct. âEveryoneâs cheery, so I canât be.â It wouldnât occur to curmudgeons to consider other alternatives, like âEveryoneâs cheery, but maybe they should be even more so!â This isnât physics, where for every action there is an equal and opposite reaction. Assessing markets and events based on a false either/or could lead to big mistakes when you consider results are not binary.
Transferring our clock metaphor to stocks, if the crowd thinks stocks will rise 10% in a year, the curmudgeons bet on down. Perhaps not down 10% exactlyâtheyâll bet on the opposite direction, but they might not bother guessing the magnitude. Their nature is to be ornery, but not ornery with precision. Simply betting the reverse direction is good enough for them.
We can transfer it to a recent scenario, too, like the Federal Reserveâs quantitative easing (QE). The crowd thinks QE is good, propping up stocks. Contrarians think itâs bad, risking inflation. Here is your false either/or! In my view, QE is bad because it is deflationary, an outcome neither the crowd nor the supposed contrarians consider. There is a century of economic theory and research supporting this notion, but the crowd buys the common narrative, which crowd-contrarians are so fast to categorically reject that they miss the truly big problem with crowd-think. There, too, theyâre just being an opposite crowd without much deep thought. (More on QE later.)
Whatâs the problem? A clock doesnât have just two numbers! It has 12 hours, with 60 minutes in between. Even if the masses bet wrong, the curmudgeon has a 10-in-11 chance of being wrong, too. Thatâs a 1-in-11 chance of being right. Same goes with markets. If everyone calls for a 10% year, stocks need not end down for them to be wrong. Flat returns would do it. So would up 20%, 30% or more, because most who envisioned 10% would have sold out by the time stocks hit 15%. The curmudgeons who bet on down could very easily be wrongâand often are. Not that being wrong would hurt if you called for 10% and stocks did 30%, if your positioning was right and you didnât sell too soon, but weâll get to that in Chapter 2.
There Is Always a But
The market is The Great Humiliator. TGH for short. Its goal is to humiliate as many people as possible as often as possible for as long as possible. Preying on the herd is its bread and butterâhumiliates a whole bunch of investors at once! The crowd is the easy, typical prey, but TGH spares no one forever. Even true contrarians get whacked.
No approach works all the time, including assuming the crowd is wrong. Sometimes, theyâre right! The market usually doesnât do what everyone expects, but there are always exceptions. If TGH didnât let the crowd be right sometimes, there wouldnât be a crowd! Momentum investorsâthose whose guiding principle is âThe trend is your friendââwould be proven wrong the moment they invest. Markets would slap most folks in the face as soon as they buyâor sellâand people would learn from their mistakes. Stocks wouldnât have anyone to fool, and fooling folks is one of the marketâs greatest pleasures.
People must be right sometimes, must feel good sometimes, or weâd never have a herd. They would just give up. The occasional rightness fosters false confidence, reinforcing the crowdâs wisdom. It is plausible deniability for TGH. It is how TGH repeatedly sucks the crowd in, makes them ignore negatives, then doles out maximum pain and suffering. (TGH probably then enjoys a cartoon-villain-like laugh.) This is why seasonal myths like âSell in Mayâ and âSeptember is the worst monthâ ring true. Even though theyâre wrong more often than not, theyâre right sometimes. Those times when May, summer and September returns look sad, coupled with below-average historical returns for May through September, keep the myth alive. Occasional and often dramatic rightness gives myths power.
Markets often let the crowd look right temporarily, before turning on them. Folks who believed the eurozone crisis would end the bull market in 2011 looked awfully right that October, when world stocks were at the bottom of a deep correction. But stocks bounced and the bull carried on in 2012, 2013 and beyond, shrugging off historyâs largest sovereign default in Greece along the way, ultimately proving the euro doom-mongers wrong (or very untimely, also effectively wrong).
Sometimes, marketsâ wobbles let folks think theyâre right, like when a correction comes after headlines warn some big evil will rock stocks. Correctionsâsharp drops of â10% to â20% over a few weeks or monthsâcome any time, for any reason or even no reason. But fear-mongers often assume conveniently timed corrections are proof that whatever they warned about was as big and bad as they said. This isnât fundamental rightnessâjust confirmation bias (seeing what you want to see), a dangerous behavioral phenomenon, but most folks donât bother differentiating between fundamental rightness and happenstance. (More on this in Chapter 9.)
Just as the crowd is sometimes right, true contrarians are sometimes wrong. Everyone is wrong sometimes! The goal is simply being right more often than wrong, as opposed to looking right at first but ultimately being wrong more often than not.
Why Most Investors Are Mostly Wrong Most of the Time
It isnât because theyâre uninformed. It isnât because they lack smarts. Very well-read, bright people who pay close attention to the market often make pretty bad investing decisions! There is usually one simple reason for this: They inadvertently get sucked into consensus views.
Groupthink can happen no matter how careful and studied your methods are. Many folks see investing as a discipline, art or science, which sounds good, but their methods morph into conventional wisdomâusually dangerous in investing. All operate on various sets of beliefs about what is and isnât good for stocks and when you should and shouldnât trade. Or they follow rules dictating the same.
Many doctors, lawyers and engineers are prone to this. Not because there is anything wrong with them as people. It isnât their fault! But their professional training leads them there. In their professional lives, they use a rules-based methodology, and there, it works. But in markets, it doesnât. For doctors to recommend a treatment, they need scientific proof it worksâtrials and controlled tests. They apply the same methodology to investing, looking for ârulesâ that have been back-tested and âprovenâ to work. Most lawyers are logicians by trade and natureâthey expect markets to follow rules, processes and simple logic. Most engineers, too. They expect markets to be linear and rational, just like the systems they build and work with daily.
Rules-based investors usually use similar logic and reach similar conclusions. They use the same patterns, the same if-then assumptions. They end up expecting similar things, and it morphs into a consensus viewpoint. It usually appears very logical! But markets often defy logic, as weâll soon see.
Other folks take their rules and beliefs from academic theory and textbook curriculum. Theory and textbooks arenât inherently harmful. Principles and theory can be useful if you layer on independent thought. But many turn theory to dogma, textbooks to rulebooks. Whatever the literature says is good or bad for stocks must be true, always and everywhere. If the rulebook says high price-to-earnings ratios (P/Es) and high interest rates are bad, then theyâre bad! To fundamentalists, the canon is often truth. But canon is also widely readâmore consensus! Markets price in the consensus pretty quickly and do something else. That âsomething elseâ is what the true contrarian wants to figure out.
Some investors use old saws and rules of thumb as a guideâthe âplaybook.â Here, too, the approach might seem fine. The playbook is supposedly full of time-tested wisdom! If it didnât work, it wouldnât be in the playbook! But the more you base decisions on maxims, proverbs, and things everyone just knows, the less likely you are to think independentlyâand the less likely to have true contrarian views.
The playbook also doesnât pass a basic logic testâone of the true contrarianâs favorite tools, as weâll see in Chapter 4. It includes familiar adages, like âbuy on the dipsââwhen stocks are on sale, snap âem up at a bargain! But thatâs also when the playbook would tell you to âcut your lossesââget out of that dog before it goes to zero, and get into something thatâs actually going up. One page tells you to âlet your profits runââif itâs going up, stay in! I...
