5 Dumb Mistakes That'll Tank Your Contrarian Strategy
When stops start to be triggered, and margin calls are produced, it is just at the moment that we should go out and buy
Contrarian investing is one of the most profitable types of investment there is. We have already discussed it in several articles, but I recommend this one that sums up our philosophy quite well.
To summarize, this style consists of selling when everyone is buying, and there is a huge euphoria in the markets, and buying when people are selling their mother. When stops start to be triggered, and margin calls are produced, it is just at the moment that we should go out and buy.
It is one of the investment styles that can make you the most money. But the main funds worldwide refuse to implement this style because it requires latent losses in the short term.
Generally, it is complicated to buy at the lowest point and sell at the highest, so it is advisable to purchase during the falls gradually. Buying in these situations implies losses in the short term because the general rule is that prices will continue to fall. This is difficult to explain to fund participants, and therefore, the large fund managers prefer to avoid this strategy and prevent investors from withdrawing money from their funds so that they can continue to receive commissions.
Independent investors, who happen to be the most profitable, have made a lot of money during bear markets.
The clearest examples are Warren Buffett, Oaktree Capital, or Mark Spitznagel.
But there are a series of mistakes that you can not breach under any cause, these are:
Try to make this investment with shares.
Indeed many people are against this principle. And they will probably justify it to me, and I can understand it. However, I do not recommend anyone to average during downturns in specific stocks.
I have been thinking about this for a long time, and I have concluded that the share price picks up factors that only a few insiders know about, while the market still does not. This means that when a stock price is down while the rest of the market is uncorrelated, it tells us that there is something that the individual investor does not know.
If it is a good company, it may return to its previous price, but it is a risk that we should not waste time trying to discover.
It is wiser to buy an index during downturns than to purchase individual shares. And if not, look at the example of Telefónica. What happened to the one that averaged down?
When the market is a falling knife.
“The market goes up in staircases, but down in elevators.”
During March 2020, we saw the major indices contract by as much as 35% in a couple of weeks.
Individual investors typically tend to do, is when they see 5–10% declines, they automatically put all their liquidity to work. Not taking into account that these drops are expected and could be prolonged exponentially.
It is much more sensible to average an index as it falls. Or have a pre-established system. For example, if my portfolio is 50% equity and 50% cash. When I have a 60/40 or 40/60, I buy or sell until it rebalances.
Having patience in this type of situation is key. I would also say that if, during the fall, you have ended up with cash in your pocket before the recovery, you have done it correctly.
Selling options disproportionately during downturns.
Selling options when the market has fallen is an excellent option to make (a lot of) money. When everything has fallen, and both volatility and implied volatility have risen disproportionately, we can find many bargains in the markets.
If you start buying shares in the major indices by selling options, you can get an alpha to do it directly in the market.
The main problem is that people do not know when to sell PUTs. This makes them take many risks, and if the fall is prolonged, their losses grow exponentially.
Every retail investor should learn a great lesson that the IV is usually elevated for longer than the prices. This means it is preferable to wait to sell PUTs than to try to “miss” the opportunity, and FOMO loses a lot of money.
Thinking that it has already bottomed out.
“-30%, it can’t fall any further”. People like to try to get it right. They try to predict if it has already bottomed during the dips. And you want to know one thing, neither you, nor me, nor anyone else knows.
Anyone who tells you they know if it has bottomed or not is a liar. And since no one knows if it has bottomed or not, it is always beneficial to average.
The way to average should always be to follow a pre-established system. If you have a plan and follow it, you can be sure that you will be on the right track in this investment. If you don’t have a system, you are lost.
Do not diversify during downturns.
An asymmetric portfolio is the big difference between having more or less liquidity during downturns. An asymmetric portfolio does not mean having 20% in technology, 30% in retailers, and 50% in utilities. This is not diversification. When you diversify, it has to be among assets that are not correlated with each other.
A clear example we are seeing now is what we are doing with our portfolio. While the market is falling and we are losing money with our indexes. We have bought options to buy these indices at a lower price and even make money.
The same thing happens with gold, right now, it is holding up this beginning of the year 2022 much better than the indices are doing, and it can allow us to sell at a profit and buy at a much lower price other assets.
There are market situations in which these percentages are inverted, and we must adapt them inversely.
Having an asymmetric portfolio is a guaranteed success. Whoever says it is not is lying. We have the evidence in the big investors. Or tell Warren Buffett when he confessed in November last year that BRK had never had so much cash on its balance sheet.
What did he do?
Sell when everyone else was buying.