The art of successful investing is to act contrary to the crowd. That was the theory of one Fred C. Kelly back in 1930.
In Why You Win or Lose: The Psychology of Speculation, Kelly wrote about his experiences with the market and the timeless lesson he learned:
I learned that men win or lose not so much because of economic conditions as because of human psychology. Certain mental traits that we nearly all have are barriers to success.
Therein lies the crux of Kelly’s theory. If most market participants behave normally, and normal behavior typically leads to mistakes, then the answer is to not act normal.
I believe the way to win is to do exactly the opposite from what nearly everybody else is doing. In other words, one must be contrary!
Yet I know, simple as this formula seems, few will ever follow it. Indeed, if many followed it, then it wouldn’t work. If everybody tried to buy when prices are low, then bargains would never exist. A few find bargains only because the majority never recognize bargains. The crowd always loses because the crowd is always wrong. It is wrong because it behaves normally. Every natural human impulse seems to be a foe to success in stocks. And that is why success is so difficult. If you think it is easy to do invariably the opposite of what seems to be the sensible thing that everybody else is doing, just try it. At every step, one is tempted to do that which seems logical, but which is nevertheless unwise.
Less than a year after The Great Crash of ’29, the self-proclaimed “amateur psychologist” summed up in about 80 pages what people have written about ever since — the many ways investors are their own worst enemy.
He covers the basics of vanity, greed, and fear, but where investors really go wrong is logic. Today, someone might call it first level thinking.
The most logical thing a market speculator can do, indeed, and the thing he is most likely to do, is to buy when prices are high, and sell when prices have dropped, thus suffering a loss. Unwise as this is, it is nevertheless logical, because when stock prices are highest all the information drummed into one’s ears is favorable, indicating that soon they will be still higher. But when prices are at their lowest ebb, all that one learns from the newspapers or from conversation with knowing friends is discouraging. To a mind that works logically, it is obvious that the worst is to come, and that the end of the downward swing is not yet.
Anybody knows that when a thing has happened over and over again the presumption is in favor of its continuing to happen in the same way… It is this disposition to expect a stock to continue in the same direction that it has been going which leads people to buy at top prices after several days’ rise, or to sell after several days of decline. Because you have thus arrived at a logical conclusion, on the very day that you decide to buy the stock goes not up but down.
Naturally, when all who can be induced to buy have bought, and there are no longer more buyers than sellers, the only way the stock can move is downward. But if you have a logical mind, you do not get excited as your stock drops… After it does this for a week or ten days you repeat the logical reasoning you followed when it was advancing. You now decide that it is likely to continue dropping indefinitely.
The mistake of buying high and selling low seems obvious and yet…investors still do it today.
The initial conclusion — the first level thought — is often the wrong one because everyone else thinks it too. And when the majority of people start thinking the same way and doing the same things, then its already priced in. The end result becomes average. The only way to avoid it is to act differently than the crowd.
It must be evident by this time that the only safe method is to be illogical. If you are logical you merely do what everybody else is doing. You can’t make money that way any more than a group of people can get ahead in the world by washing one another’s clothes. You can make a profit in the market only by outwitting the majority of other people. But you can’t do that if you follow the same plan that they do.
But to act opposite the crowd’s tendencies? A few people are wired for it and some might learn to do it but nine decades since the book was written suggests human nature is still undefeated. It’s hard to be illogical, much less look temporarily wrong, when the media and everyone else spews logic. Following the crowd is the emotionally easier path and requires less time and effort.
Kelly sums up his version of contrarianism this way:
To understand the market, one must think of the human element — of the great mass of unthinking speculators and investors who are going to be wrong. No two speculative moves are ever the same; no two markets are ever alike; and no two market manipulators ever operate alike. It is like a bridge game in which the same combination of cards may never occur again in your lifetime. But if you play carefully and watch each move of the other fellow, you nevertheless have a chance to come out ahead in the long run.
You can’t beat the stock market, we are assured, any more than you can hold back the tides. But why try to hold back the tides or to overcome an irresistible force of any kind? Instead of trying to pick a fuss with the tides, why not ride with them? In other words, as a politician once said to me: “If you can’t lick an organization, join it!”
The stock market moves up and down in great waves. Most people, being less smart than a few people, invariably mistake the trend of these waves and therefore buy and sell stocks at the wrong time. To get aboard the tide at the right time, it is only necessary to disagree with the opinion of most of your neighbors who are following what they consider logical reasoning processes.
Be contrary! But be cautious!