Contrarian Buying – A Way To Increase Profit Potential and Risk Control

Monday, March 1, 2010

Ever buy a stock and then marvel at how the price immediately started down? After making such a trade, you are faced with two mental challenges:

  1. Questioning the wisdom of having bought
  2. Wondering if you should sell now to minimize the loss (See Ennui Risk, below)

If you do hang on and then see the stock climb, your results include two negatives:

  1. Spent emotional capital on the previous two items
  2. Reduced gains because the stock must first make up lost ground

Being a contrarian buyer can mitigate these items, increasing your potential return, reducing your risk of loss and improving your investing experience.

As described in “It’s Time To Be a Contrarian Investor”  and the subsequent three-part contrarian investing series, going against the grain is an important investment approach. Complementary to this thinking is contrarian buying, a way to improve both performance results and staying power.

Contrarian Buying Mathematics

Look at how well contrarian buying can improve your results. Let’s assume a stock appears to have a potential value of $60. It has recently risen to $40 on some good news. We can either buy now, to ensure not missing out on a further rise, or we can wait, hoping for a “pullback” meaning one of those inevitable price sags after the good news excitement fades. Let’s further say that we set a price of $30 as being the cutoff for holding the stock. That is, we believe if the stock drops that low, something is wrong and we will sell. Here, then, are the mathematics of buying now at $40 versus waiting for a pullback.

Contrarian Buying Steps

  1. Commit to buy only on pullbacks and never near a recent high price or on obvious good news. Yes, there are those times that good news is followed by more good news, piling gain upon gain. But they are rare, so not waiting for a pullback means most trades will suffer the adverse results listed above. (See Opportunity Loss below)
  2. Place orders in advance at the price you are willing to buy. This means a “limit-buy” order at a price below the current one. Make the order GTC (good-till-cancelled). That order will operate as your proxy, a full-time trader ready to buy your stock whenever the price drops, even if only for a fleeting moment. (See GTC Orders below)

Example – Intel

I discussed Intel (INTC) as an interesting stock in “Another Way To Pick a Stock in Today’s Market – Think Growth.” On January 14 it rose to a new 52-week high on large trading volume. After that, it drifted down. Look at how different your results would be (and how different you’d feel) buying at that high ($21.38) versus at a pullback of 10% ($19.24). The former means you’ve been running a steady loss for one and one-half months bringing on questions of “what’s wrong?” and “did I make a mistake?” The latter is showing a nice profit, and you are comfortable, feeling the stock has shown good support in this unsteady market period.

FYI – Other companies I have discussed because of interesting prospects are Boeing (BA), Caterpillar (CAT), Coca-Cola (KO) and Wal-Mart (WMT). All are in various stages of pullback.

How About Now?

As I wrote at the beginning of the month “The Stock Market Roller Coaster – Enjoy the Ride“, mid-month periods often are good times to buy. The period we’re in now (mid-February to mid-March) is especially good because year-end 2009 earnings reports are past and first-quarter 2010 ones are a ways off. The market is back to its seesawing ways, as economic indicators and uncertainties whip investors about, thereby giving us pullback buying opportunities.

So, contrarian buying is a powerful tactic for successful investing, and now looks like a good time to apply it.

– – – – –

Ennui risk

Ennui (a feeling of boredom or dissatisfaction) can occur after buying a “hot” stock – one that is popular, in the news and rising. Having acted, the typical cooling off period (as traders and commentators move on to the next hot item) feels like a negative phase, with the investor holding a tired, forgotten stock. Thoughts are strong that the investor should sell (at a loss) and move on. Ennui risk is purely psychological and can be avoided by buying on pullbacks.

Opportunity loss

Everybody hates the thought of missing out on easy stock gains. That is why so many jump aboard a rising stock. The risk they see is that, by not buying, they could miss out on large, quick profits. The possibility of missing out is called an “opportunity loss.” But it is not a true loss. Rather it is in the “would’a, could’a, should’a” camp, where “if only I had…” emotions rule the roost. Granted these feelings can be powerful – but that’s all they are: feelings. Most importantly, most stocks don’t go straight up, so we need a smart game plan that ignores long shots and wisely plays the odds. We can make more returns and prevent more losses by not worrying about opportunity losses.

GTC orders

These orders are powerful because they take place dispassionately. We don’t have to analyze why the stock fell to the price we wish to buy. In fact, it’s better not to know because our resolve might be shaken. (This is why brokers humorously refer to such orders as “good-till-close” meaning they see investors get frightened out of their “good-till-cancelled” orders by seeing the negative news that got the stock down to the attractive price.)

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John Tobey on Seeking Alpha

Seeking Alpha Certified

March 2010