Note from Paula: Every Friday I review a book. Check out a complete list of the books from my Weekend Inspiration series.
This week’s book is The Art of Contrarian Trading by Carl Futia. The book is based on this premise:
Sometimes, the stock market’s prices are justified by reality. Other times, however, either enthusiasm or fear carries the market away. When that happens, stock prices become downright silly.
If you can avoid herd mentality, Carl says, you can profit from these “market mistakes.”
How an Investment Crowd Forms
Carl explains – in a nutshell — WHY emotions carry the market away. Here’s an example: In 1998, crude oil traded at $11 per barrel.
At that time, there was a small group of people who believed that – sometime in the 21st century — we will hit the limit of our ability to extract oil at a cost less than the rate that buyers are willing to pay.
In other words, these investors believed that oil prices MUST go up until some point in the early- to mid- 21st century.
So these guys invested heavily in crude oil.
Now, in 1998, oil traded at $11 per barrel. By 2004, it traded at $40 per barrel – a 400 percent gain over the span of a measly six years.
Needless to say, the people who invested heavily in crude oil in 1998 became rich, rich, rich. Here’s where “herd mentality” starts entering the picture.
Other investors saw the success of the 1998 crowd and interpreted their success as “proof” that their theory was correct. More investors jumped on board – after the price had already skyrocketed 400 percent.
Nevermind that the underlying premise stayed the same. Nevermind that the underlying premise – in 2004 - was just as sound or unsound as it was in 1998.
When the “early adopters” are successful, a herd forms.
You can see the logical fallacy here:
Some investors say the price of oil will always go up. The price of oil went up for the last six years. Therefore, these investors are correct.
It’s a logical error, but who cares? The market is exuberant now. Look at that 400 percent gain! I could get rich!
At this point, the fair market value can go overboard. Then you have a bubble. (By July 2008, crude oil hit $145 per barrel!)
When the bubble pops, you slide from overvalued to undervalued with no stop in between. (In December 2008, it crashed to $30 per barrel.)
Instinct Says: Join the Crowd!
Our deepest instinct tells us to join the crowd, Carl says.
Humans are social creatures. We rely on each other for food and protection. Our survival depends on being a member of a community.
To be a contrarian, we have to defy that instinct. We have to be a little bit of an outcast, an outsider – the person who does the unconventional.
We have to be strong enough to maintain that position for years, Carl says, even as the voices of the herd chip away at our resolve.
(As a side note, Carl is a huge advocate of passive investing — because he believes most people can’t avoid the herd mentality.)
The Bottom Line
The ideas in this book are so strong that I’m going to devote another post, next week, to exploring more concepts that I didn’t get a chance to address today.
This Book is For You If:
You’re ready for an intellectually rigorous discussion about the market.
This Book is NOT For You If:
You want easy reading. This ain’t no light read. This book is NOT “approachable”– it’s weighty and rigorous.
Read more about The Art of Contrarian Trading: How to Profit from Crowd Behavior by Carl Futia.
I’d Like to Thank the Academy …
- Thanks to the Carnival of Personal Finance for choosing me as an Editor’s Pick! Wahoo!
- Thanks to the Totally Money Carnival for another Editor’s Pick award! Hooray!
- Thanks to the Festival of Frugality for featuring me.
- Thanks to Katrina Tuliao for today’s photo.
This sounds like a really interesting book. It feels sorta strange to me that more people haven’t caught on to this by now. Maybe that’s why Americans have such a large appetite for expert stock picks and CNBC shows about the market.
I just watched a movie not too long ago about this same thing. It was about the debate over whether the market was controlled by rational economics or behavioral economics…and it looks like Futia sides with the behavioral approach. I couldn’t agree more. Although my knowledge in this area is primer at best.
Paula,
Contrarian trading is well and alive but the only problem is to successfully predict a trend. I am a big believer in buying a stock at higher price to sell it at even higher as long as it has strong fundamentals and growing earnings. If you read William O’neal’s books on investing, you will find out that some of the well-known major corporations of past have perished.
I think it is always smart to buy when the stock or commodity is cheap; but it’s also akin to catching a falling knife which can hurt you if you don’t know where the bottom is.
Thanks,
Shilpan
I just finished “A Colossal failure of common sense, the inside story of the collapse of Lehman brothers”. It is classic examples of what you are talking about. One part of Lehman had the herd mentality on real-estate, another part of Lehman, was actually betting against the very bubble Lehman was participating. The book is appropriately named.
Such books are really quite interesting. The truth is that there are so many different facets to investing and being able to understand investor psychology really does provide an advantage.
I remember a friend from the Philippines who told me about a situation like what you mentioned.
Early in the last decade, there was a craze over fresh smoothies. You can see someone selling it on almost every street corner. Now, only the originators of the craze were the only ones selling the product.