Tuesday, November 26, 2013

The Myth of Contrarians

One of the first things all investing books mention is the importance of being contrarian, that disagreeing from the majority is what allows the greatest profits.  But in financial markets, as convenient as that explanation is, contrarians do not and cannot exist.

First, something we can all agree on: for every buyer there is a seller of equal dollar amounts.  So for every dollar that believes in a stock and thus buys it at that instant, another dollar has to hate the stock to sell it to him.  On net, there is always an equality, never the majority that contrarians need in order to exist.

So when Warren Buffet says to buy when everyone else is selling, it is a bit flippant.  If everyone is selling, then the markets are not trading as there are no buyers.  But that's not what we see during bear market bottoms, ie when "everyone is selling."  Rather, we see the opposite: volumes explode to extraordinary levels, signifying that the markets are trading and at a greater clip than average.  Thus, even in the most extreme market conditions, it has to be true that the number of people dying to get out of stocks is equal to the number of folks dying to get in (in dollar amounts).

Instead of dividing up the market into buyers and sellers, recognize that they are two sides of the same coin.  One cannot be a buyer unless another steps up to sell.  Rather, the distinction should be made between the two major types of traders: trend followers and mean reverters.  Trend followers...follow the trend.  If the price has been going up, they buy at progressively higher prices.  If price goes down, they begin to sell successively lower prices.  Mean reverters do the opposite: as price goes down, they begin to buy and sell when price rallies.  (This is what Warren Buffett actually means when he says buy when others are selling.)  In essence, these two groups are each other's liquidity.  As prices go up, mean reverters are looking to sell while trend followers want to buy.  As prices go down, mean reverters look to buy while trend followers begin to sell.

This is why a lot of investing axioms seem to contradict each other. Memorable speculators like Jesse Livermore warned against betting against the trend: "When I am bearish and I sell a stock, each sale must be at a lower level than the previous sale. When I am buying, the reverse is true. I must buy on a rising scale. I don’t buy long stock on a scale down, I buy on a scale up. " or as PT Jones used to say: "Losers average losers." Meanwhile, value investors like Warren Buffett and Seth Klarman tends to do the opposite as the latter famously said: "Yet if the security were truly a bargain when it was purchased, the rational course of action would be to take advantage of this even better bargain and buy more."

In a way, these legends were only successful due to others not following their advice.  Klarman couldn't buy more at cheaper prices unless Livermore sold them at cheaper prices.  Perhaps this is why most people will never be successful in this game: aside from hedgers, for your purchase to be correct, someone else had to be wrong as he sold too early.  What are the chances that you are consistently right?