Salmon is a common name for species of ray-finned fish in the family – Salmonidae. They are born in the fresh waters of the rivers, and then migrate to the sea to develop and grow. And then they travel back hundreds of miles to return to the fresh water to reproduce.
What is even more fascinating is that the Salmon completes this resolute journey travelling against the river flow. This journey, swimming up the river going against the current, is called the Salmon run.
The fish use their skills, environment and perfect timing to accomplish this feat. First, they use the high tides in the ocean to get close to the rivers, then through their sense of smell, they home in on the river entrance. They also time their swim upwards gauging the river flow. The difficult parts are the waterfalls they encounter during the journey. But the fish manage them with skill and timing.
The Salmon can flex its body and leap more than 10 feet in the air. It times the jump and uses the strong upward current created when falling water displaces the water beneath it. The combined force works and the fish is able to clear the obstacles and reach its destination.
Against the flow in the markets
Like Salmon, one species of investors who show similar skill and grit in the market are called ‘contrarian investors’. They go against the flow, taking non-consensus positions and timing their trades when the crowd is overrun by panic or euphoria. Most people define contrarian investing as buying when many others are selling and selling when the crowd is buying. That’s a reflection of the action taken, but certainly not the thought behind contrarian investing.
The crowd is not wrong all the time. And the contrarian investor is not the one who expresses a stubborn dissent to market opinions all the time. In the stock market, we often hear that ‘the public is right during the trends, but wrong at the ends’. The crowd is wrong at turning points and that is the precise point where a contrarian investor tries to position and take advantage of the possible change in trend.
Contrarian investors try to identify areas of the market where the crowd has overreacted, and position themselves to benefit when market realises its mistake. There is an old French adage about investing, “Buy on the cannons and sell on the trumpets.” It suggests buying when people panic and overreact on the downside in a war-like situation or crisis, and thereby create good opportunities to invest. On the other hand, when wars end and peace times reign (trumpets blowing marking the end of the war), people tend to display euphoria and begin a buying frenzy; those tend to be good opportunities to book profits.
Genesis of contrarian investing
Proponents of efficient market hypothesis believe people behave rationally while making investment decisions:
- They incorporate any new information perfectly into the price (using Bayes theorem).
- They make optimum allocation decisions (based on calculated expected value or the efficient frontier).
They also believe in the wisdom of the crowds:
- While individuals may suffer some biases in their decision making, the crowd does not. When different individuals interact in the market, their errors cancel out each other, and hence, prices are close to their fundamental values.
- In case there is a net bias which is not negated, there are arbitrageurs who will come in and trade in a way that they make a risk less profit and the prices again revert to the fundamental values.
In reality, people are not so good with handling complexity and uncertainty. Individuals investors are not perfectly rational in their financial decision making and do get affected by biases. As mentioned, most of the time, the crowd can be right.
However, the crowd is influenced by narratives, they extrapolate recent trends into the future and often ignore regression to mean and base rates. This can lead to imitation within the crowd and results in herding. Herding breaks the diversity in the market and creates a market bias.
A feedback loop sets in which pushes the market prices further in the direction of the bias and reinforces the trend. Behavioral economists have shown that in such conditions, arbitrageurs cannot really influence the prices. The crowd ends up being positioned at one extreme side of the market (overreacting in optimism or pessimism). This is the opportunity for the contrarian investor. An opportunity to buy from the pessimists or sell to the optimists.
The challenges in the path
Life unfolds in cycles, but people project it in straight lines. In the market cycle too, booms are followed by busts, excesses sow the seeds of reversal. The contrarian investor understands and profits hugely from this behavioral cycle. Unfortunately, this path is not without obstacles.
- Needs knowledge of fundamentals and psychology: To understand if the market prices are unreasonable in either direction, the contrarian investor must have a good handle on what is the reasonable value. It is important to have grasp of the intrinsic value before claiming a security or asset is mistakenly over or under valued. The investor must also understand the behavioral cycle of the market. Since many investors are trend followers, they may rush in to participate in a bubble and stretch it further.
- Timing is important and difficult: ‘Markets can remain irrational longer than one can remain solvent’. A contrarian investor disagrees with the crowd but should know when to act on that disagreement. After establishing a position, the investor may have to wait for a long time. The crowd may take a lot of time to finally change course. Remember, by its very construct, the contrarian investing is about being early.
- Standing alone is difficult: Being a contrarian investor is contrary to our natural reaction. Resisting temptation to participate or conform to the majority, standing alone against the crowd, betting against what seems obvious etc. is a difficult position to maintain psychologically. It takes courage and perseverance.
Get the set-up right
The strategy is right: a contrarian investor buys when the prices are low and sells when they are high; logically, there is a lot of money to be made. It sounds simple but it has its own challenges. Keeping the right set-up may help implement the contrarian strategy effectively. Some of these ideas may help:
- Have a screener to hunt for contrarian opportunities.
- Make a checklist of conditions that help qualify investments.
- Build positions slowly – as you can’t predict the exact top or bottom.
- There is a need for patience – you, your clients, your management and sponsors.
- Be prepared for looking stupid till you look intelligent! You may have to lose the battle to win the war.
Credit: Stocks-Markets-Economic Times