The contrarian approach

What is the contrarian approach. In a contrarian approach we do exactly the opposite of what the majority is doing. To understand that lets see first what is crowd behaviour
in the stock market. Crowd psychology in the stock market is no different from that seen anywhere else. Crowd behaviour is the mentality of following the herd. It is going with the majority opinion. This means when the market is trending i.e. continues in its direction whether up or down , everybody is eager to join the bandwagon so to say. In the early stages of the trend though this gives the desired result and more people join in giving further boost to the already developed trend. But all trends reverse at some point. The trouble with the crowd is that it does not know when and where to get off the bandwagon. That is because crowd behaviour essentially precludes any logical or rational thought process and all actions are dictated by following what everybody else is doing.

Now everybody cannot be right at any given point of time. This should be very simple to comprehend. For if every body is right and is able to make profits where are the losers going to come from. In any transaction both the buyer and the seller cannot be right . Either the buyer is right or the seller is right. If the buyer is right he stands to make profit on his investment and vice versa. In fact a buy sell takes place as a result of opposing views of the buyer and the seller. Since there are as many buyers as there are sellers simple arithmatic tells us that at least 50% of people are loosers. This without any further mistake on the part of the investor. If investors make further mistakes, which they invariably do, the number of loosers far surpasses the winners in the stock market. This is a very important aspect of investing in stock markets and has to be kept in mind. Winners in the stock market are few. So following the majority does not pay.

This is the contrarian approach. You sell when others are buying and buy when others are selling. That is buy in an atmosphere of gloom and doom and sell amidst euphoria. Buy into companies which have been neglected by the market, if the fundamentals are right and wait patiently because markets will eventually catch up with the fundamentals and reward you. But here is a caveat . This approach works when a majority opinion has indeed been formed among the participants in the market. But if one takes the approach before that , i.e. when the majority opinion is under formation one will miss out on the opportunity thrown by a trending market that is a rising or a falling market.

But how does one go about figuring out whether a majority opinion has indeed been formed. Tracking the P/E multiple can be a very useful method. The P/E ratio is obtained by dividing the price of the stock with it's earnings per share. Obviously it indicates how far the price has gone in relation to the company's earnings. P/E multiples are very high or low at around the time when the trend is maturing that is when a reversal is imminent as the trend does not seem to have any more legs to go on whether up or down. In such a situation the P/E ratio has strayed very far from the value it normally commands. Following the P/E ratio therefore gives us a reasonable idea as to the extent of the price rise or decline. But one has to be careful here, as sometimes, price of a company's stock rise or fall dramatically following some unexpected news on the company and so does the P/E multiple. In such a situation it is helpful to compare with other companies in the sector. Sometimes also unexpected events take their toll on the markets which then stands rerated or derated depending on whether higher or lower P/E multiples are paid. But that is a different thing. These days P/E ratios are given with stock quotes of most newspapers and it is very good practice if one makes it a point to keep tab on the P/E multiple.

Happy investing.