Contrarian Investor

18th January 2012

It's easy to get sucked into press chatter surrounding stocks, and the knowledgeable investor may keep a careful eye on the moves of traders on the money markets. But noting the price data, which may distort the picture of an underlying trend, or following the tone of a market through ‘crowd psychology' sentiment, could prove an expensive mistake. The dotcom crash is just one example of hype surrounding a sector that then saw stocks take a dramatic dive – and with the rise of social media platforms, we're more likely to be drawn into a ‘trending' topic.

As Psyfi blog says: "…a contrarian investor should be looking to bet against the noise traders…so it's of significant interest to figure out what the current sentiment of day traders is." So what is being shouted as the next ‘buy' may often be the stock to avoid. As the blog continues: "Irrational noise traders are dominating proceedings by synchronising their behaviour."

The earliest research into the noise trader phenomena was Noise Trader Risk in Financial Markets, by De Long and colleagues, which says:

"Much of the behaviour of professional arbitrageurs can be seen as a response to noise trading rather than as trading on fundamentals. Many professional arbitrageurs spend their resources examining and predicting the pseudo-signals noise traders follow in order to bet against them more successfully. These pseudo-signals include volume and price patterns, sentiment indices, and the forecasts of Wall Street gurus."

Social media and the amplification of noise

A lot of the noise these days comes through the twittersphere – so investor's decisions are made not on old-fashioned fundamentals.

The growth of the internet and social media platforms has led to a new flow of information for investors to take hold of – or ignore. Tweets around a specific stock are, after all, often correlated to its performance and volatility. But does this conversation contain real, useful information? Does the conciseness of tweets improve or distort the clarity of information? How can you tell a reasoned slither of investment information from an irrational one? But whatever the answers, tweets do affect markets.

Psyfi blog says that in Predicting the Future with Social Media, which has come out of HP Labs, using sentiment analysis they showed that:

"The rate at which movie tweets are generated can be used to build a powerful model for predicting movie box-office revenue. Moreover our predictions are consistently better than those produced by an information market such as the Hollywood Stock Exchange, the gold standard in the industry."

However, on the concept of a contrarian investor avoiding market noise, Kim Stephenson, Mindful Money's resident psychologist blogger, says:

"One person is listening to gossip and doing what it says, somebody else is listening to gossip and doing the opposite of what it says.  It sounds to me like both are listening to gossip and making their investment decisions based on that gossip. 

"Perhaps the idea is that you ignore the short term press comment, social media etc. and invest for the longer term, for when the market "corrects".  But how do you know what it corrects to, maybe that's the result of other people listening to the gossip in a couple of weeks or months? 

"I don't hold myself out as an investment expert, but when all the evidence from research by people like Barber and Odean, the studies of day trading and high turnover, and the advice of both theorists like Malkiel and practical investors like Buffet is to try to look long term – look for inherent value, ignore the market noise and not trade too much, I don't know of any particularly good argument for diving in and out of a market based on what the gossip is saying, whether you do what it suggests or do the opposite. 

"I can, however, understand the psychology behind it – investors want to think that they are, like Mourinho, "the special one" – the problem being that the odds are that they are going to be another losing statistic in the long run.  If people consistently made money from listening to gossip, there's be some studies that show evidence of it, the absence of studies like that suggests that either somebody has the secret and isn't telling anybody, or more likely that nobody actually does it consistently, sometimes some people get lucky, but their luck doesn't last and most people never get lucky at all."

For investors with a long time horizon, the right asset class will count for a lot more than market noise or sentiment. If you take note of trends or stock picks, beware of who to listen to and who to ignore before ploughing capital into an investment in the hope of making a swift buck.


More on Mindful Money

Why investors should avoid oversimplifications

Seeking income? Try an alternative


Dividends: Are high yielding companies safe?

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