By Stock Advisor Group's Editorial Team

bd_pfahimi[at]yahoo.com
www.stockadvisorgroup.com

When the stock market starts going up, most people are, initially, scared to step aboard. It's not until stocks have gone up a long way for a long time that most investors become interested and start buying. On the other hand, when stocks start dropping, most investors are not afraid. Their courage has been strengthening by the steadily rising price. Only because the market has risen a long way, investors believe it will keep going up. It is almost a gold-rush mentality.

Contrarian Investors buy on bad news, and sell on good news. "Buy low, sell high", That's how an investor must think in order to make money.

Contrarian investing is not new. In fact, it has a long history. But a review of the most recent articles on contrarian investing show that there has been a gap. Because contrarian investing can be a difficult strategy to follow, and requires commitment and discipline to make it work.

The Contrarian Thinking: A contrarian investor evaluates the opinion of the investing public, and when that opinion gets an unreasonable extreme, invests against it. Why we can profit from contrary opinion:

The basic concept is that if a most traders are bullish, it means that most market participants who believe prices are going higher are already long, and therefore the path of least resistance is down. A similar line of reasoning would apply whenmost traders are bearish.

This is true for both market tops and market bottoms. At the top, investors have committed all their money to the market, meaning there is no more money available to push it higher. At the bottom, these investors have taken all their money off the table, and typically will refuse to invest in until the market renaissance is clearly under way.

It is also critical to remember that a contrarian point of view is just an entry and exit technique. You are looking for the right time to buy and to sell, and are using the crowd's opinion to tell you when the time is right. But once you've taken a position, you want the majority to come around to your point of view. Then, you can stay with them for most of the ride. Only the majority can push the price of an investment up or down enough to create the kinds of profits you want to earn. After you buy a stock, you want other investors to see the bargain you spotted≈and you want them to pile in, to drive the share price higher.

Most of the time the majority will come around and see what you saw. Once you've purchased that stock, you need to be able to flip your thinking and go along for the ride. That's the great irony of contrarian investing. Most of the time, you're actually going along with the crowd. The crowd is wrong at the tops and bottoms, when you're buying and selling, but in between the group actually sees things your way. You're just trying to get in before the crowd when you're buying, and out before the crowd when you're selling.

For every true contrarian, there are hundred investors who falsely claim the contrarian mentality. Many are value investors, who often choose the same beaten-up stocks contrarians are buying. But the value investor is merely looking for bargain stocks. Those selling at discount to their actual value≈and isn't as interested in extreme opinion. Just because an investor takes an unpopular attitude, disagrees with the crowd, or buys stocks trading at their lows doesn't make him a contrarian. A contrarian is interested in extremes in market reaction, not just disagreement with the majority.

In short, by using these rules, the contrarian will hardly ever buy a stock unless almost everyone else hates it. It's not enough to have many investors saying bad things about a company's shares.

The advantage of Contrarian Investing: Buying and selling when others won't. In buying, you've already bought your ticket and have the best seat in the house when the investment crowd start bidding for their own spots in line. In selling, you are out the door before the others, and won't be crushed when the crowd rushes to get out of a stock. That doorway can be pretty narrow!

Liquidity drives markets. By getting in early, you are in a position to let other investors drive up the price of the shares you already own. Likewise, you are out before investors start taking money off the table when the prices of those shares start to fall.

You will also find that disgraced stocks often create less risk, as the bad news has already been built into their prices. In a falling market, that means stocks that already were trading near their lows will frequently drop a lot less than shares that had been trading near their highs.

Since a contrarian takes action against the crowd, all the other investors already will have pushed the individual stock, industry sector, market index, or commodity to an extreme price. That, by definition, allows the contrarian to buy low and sell high.

The disadvantage of Contrarian Investing: Succeeding as a contrarian investor is more than just opposing with the public. If that were all there was to it, everyone would embrace this approach to investing. Being a contrarian means not only disagreeing with the crowd, but knowing when to act on that disagreement. That means looking for extremes: specifically, buying when a stock has been beaten down belowits fair value, or selling short when the price of a stock has been pushed up above its actual worth.

But estimating extreme sentiment can be quite difficult. Actually, it's the point at which many people go wrong in contrarian thinking. You need a real extreme in order to act.

the difficulties OF contrarian thinking

Thinking like a contrarian will be difficult as you are bucking existing opinion. When everyone around you is bullish on the stock market, it takes a strong courage and an independent mind to be on the lockout for the chance to bet the other way. We all want to fit in. But as a contrarian, you must become a detached thinker and learn to be comfortable as a loner. Indeed, being alone is reassurance to the dedicated contrarian.

Contrarians can often pull the trigger too early. Doing so means they are not only alone in their opinion but, for a time, are wrong as well. That loneliness can be disturbing when nearly everyone you talk with has a viewpoint that's opposite yours. The role of the contrarian can be lonely indeed. But, for contrarians to profit, all the other investors have to be wrong when you are buying or selling your shares.

Published - November 2005