Why Contrarianism Works
|April 26th, 2010||
|Contributed by: James Berman, JBGlobal|
|In just over a year, the Dow has recovered to 11,204, from 6,547. The biggest rally of our lifetimes has lifted markets over 70%. Paradoxically, now's time to be more cautious, while a year ago was the time for optimism. Why was optimism warranted when the world was falling apart? Why is caution more appropriate now? The answer lies in the nature of markets.|
To go against the grain of anything is, well, counterintuitive.
Our lives glide most easily on the broad wings of intuition. The most human elements of our lives--love, family, and friendship--are intuitive and instinctive. There's not much purpose in contradicting the natural. We are, after all, not as distant as we would like from our Neanderthal ancestors: 45,000 years is a blink of evolution's eye. For a cave dweller to ignore instinct was fatal.
Behavioral finance tells us that markets are psychological thermometers, taking our mass temperature and distilling the result into one number, say Dow 6,500 or Dow 11,000.
The market looks at fundamentals, such as earnings, cash flows and interest rates and then applies an average price to them. But whether that price is high or low depends on our collective mood.
Since markets price in current emotion, it follows that the only way to beat the market is to go against it--that is, buy when others are selling and sell when others are buying. As Warren Buffett says, "Be greedy when others are fearful and fearful when others are greedy."
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