“I have looked at the stock market in terms of crowd behaviour. The way to win is to do exactly the opposite of what nearly everybody else is doing. In other words, one must be contrarian,” he wrote in his book
Why You Win or Lose: The Psychology of Speculation.
Why it’s not easy to achieve success in the market
Kelly was of the view that achieving success in the stock market isn’t easy as doing opposite to what others were doing seemed simple, but there were only a few who actually gathered the courage to do so. “If you thought 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,” he said.
He said if many investors start acting contrarian, then the strategy itself won’t work and bargains would never exist. “If everybody tried to buy when prices are low, then bargains would never exist. A few would find bargains only because the majority never recognise them. 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,” he said.
Human psychology plays a crucial role in influencing investment decisions
Kelly says human psychology plays a crucial role in influencing investment decisions, due to which investors often sell their good securities under pressure and keep poor ones. “The important part played by vanity in stock losses was still a sealed book to me. Neither did I understand why men are inclined to sell their good securities and keep the poor ones. I learnt that men win or lose not so much because of economic conditions as because of human psychology,” he said.
The cycle of behaviour
Kelly believed the average investors are cautious and timid as they buy at the start of a rising market and show the same behaviour while selling to take only small profits. “As prices rise, they get overconfident of buying and selling, hold on too long, see every decline as a chance to buy, until the media is full of bad news. Only then, do they sell after getting discouraged, at a loss, and near the bottom.”
Kelly considered himself as a Wall Street outsider and believed there were four greatest enemies to gaining prosperity from stock market, which were vanity, greed, the will to believe, and being logical.
- Vanity is the worst enemy of investor success
Kelly used to say it is difficult for investors to take losses as they choose not to sell in the hope of getting back to even. This leads them to often sell profitable, winning stocks, while holding on to the losers. He said it is vanity that makes investors believe in market gossips and tips. The more they believe it, the more they run the risk of incurring losses.
“It is vanity that leads us to take small profits, but large losses. If you see a nervous, fidgety man, evidently not quite sure what to do, he is probably trying to make up his mind to sell and thus clinch a small profit before his vanity is in jeopardy. It is vanity that makes men sell good stocks and keep the poor ones in time of distress. They won’t sell the poor ones, because these represent a loss; but they dispose of the gilt-edge things, the stocks that show a profit, the very ones which would eventually make up the losses,” he said.
Kelly said stock prices go down much faster than they go up, as once fear is induced, it works quicker than the enthusiasm does.
- Greed is the worst influence on decisions
Kelly felt there were only a few investors who could sit back and wait for bargains. He believed greed was the biggest enemy of patience, as the worst losses happen when investors buy at too high prices when everyone is optimistic and greed is widespread. Kelly said investors buy stocks to make money, but sell them because they no longer see a chance for gain. He said optimism sometimes tends to get in the way of this because greed affects optimism.
“People are so optimistic by nature that they are not easily scared — not easily enough for their own good. Beautiful as is optimism, we must beware of it. The optimist always thinks the market is going to move upward soon. He cannot imagine a long period of declining prices. Stock prices tend to go down much faster than they go up,” he said.
Kelly was of the view that market bubbles were actually a lot like ice creams. Explaining his theory, he said, “I suppose the stock market is like this: Here I have a dish of ice cream that cost me ten cents. Robert, the waiter, comes in and says the ice cream is all gone and no more is to be had tonight. My ice cream suddenly seems more valuable to you and you offer me, say, 12 cents for it. Then Bill, who had intended to order ice cream, makes you an offer of 13 cents. You, being Scotch, can’t resist taking a profit. Bill brags so much about the ice cream that I decide I was foolish to let it go in the first place, and buy it back for 14 cents. About that time I discover, to my dismay, that the ice cream has melted.”
- Hope, the will to believe, leads to poor decisions
Kelly believed betting on highly speculative, lottery stocks were more likely to lead to losses than big returns. Kelly said when a great majority of people believed everything is perfectly safe and nothing can happen, there is a huge possibility for panic to set in, as that is the very time that stocks are most easily passed from strong hands into weak hands.
- Being ‘logical’ is often wrong
According to Kelly, most investors find it difficult to achieve success in the investment world because of their inability to be successful buyers and sellers. He felt the ones who manage to achieve success do so by going contrary to what would be generally accepted as logic.
“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 favourable, indicating that soon they will go still higher. 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. But the day you sell you are reasonably certain to mark the end of the decline, because you are not the only one who is finally scared into selling. Stocks which saw prices advance probably did so because of their merit, because of expanding business in the corporation they represent. They are, therefore, the ones most likely to keep on advancing,” he said.
Kelly said wise investors do not buy a stock until it has been through severe tests and shown an unwillingness to go any lower. But most investors are, too, impatient to wait for a stock to show its mettle. “Most of us in our zeal for bargains are poor judges of bargains. People remember a stock’s former high price long after they forget that it also had a former low price. We may think a stock is cheap simply because the price is lower than it was yesterday, disregarding the possibility that it may be still lower tomorrow,” he said.
Kelly said when a stock drops sharply and actively to the lowest price in a long time, but during three months thereafter fails to go still lower, then it is probably going, not lower, but higher.
- Why should investors follow a contrarian investing approach
Kelly believed that in order to succeed in the market investors may not know what the highly intelligent minority are doing, but by watching and studying the crowd, they can pick up useful clues as to what that same minority are not doing. “Those of us who are only moderately intelligent and might not behave wisely by independent effort always have the opportunity to join up with smart folk, if we’ll just consistently pay no attention to all the signs which say: ‘Follow the Crowd’,” he said.
Kelly believed that, but this is easier said than done as investors need to recognise what the crowd is doing, which is not always obvious. Also, they have to avoid the temptation to follow the crowd, as investors take comfort in doing what others are doing, even when it’s wrong. Kelly felt another reason for behaving differently from the majority was that the human mind was inclined to go back to the last experience in the market and judge the future by that.
“Most people look back rather than forward… The average speculator thinks stocks that went up in the last bull market are the ones most likely to go up in the next one. Hence, one must steer clear of mere average judgment,” he said. Doing the opposite of the crowd tends to follow the value dictum of buying low-selling high — ( of buying bargains and selling at a fair price). It also does another important thing: it avoids losing over winning.
“I shall always follow the hypothesis that it’s more important to avoid losing than to win. Losses hurt one’s morale. When thinking of buying a stock expected to rise, I shall first of all ascertain if its earnings and outlook make it reasonably loss-proof,” he said.
- Stock market is not everyone’s cup of tea
Kelly believed investors who are stubborn and not ready to adjust according to the market volatilities are not likely to find success in the investment world. “I’m convinced that many highly intelligent people have no business dabbling with stocks at all, because they are too handicapped by temperament not suited to this particular game. To begin with, the stock market is no place for a person who lets strong convictions take root in his mind and stay there,” he said.
Kelly was of the view that investors should be disinclined to look backwards otherwise they would remain perpetually unhappy. “Obstinacy may have its place among the virtues, but a mind where beliefs crystallise and won’t be dislodged is not ideal for successful operations in Wall Street,” he said.
According to Kelly, another group of investors who should stay away from the market are the ones who expect the good things of life to come too easily and, therefore, are unwilling to put forth proper effort to find out which stocks are good.
“Many a man or woman who would not expect to be successful as a circus clown, opera-singer, or grocers, without some kind of preparation or talent, nevertheless expects to be successful from the start in the stock market—probably the most intricate and difficult game on earth. The reason for this faith in success without any special qualification is doubtless the almost universal belief in luck,” he said.
According to Kelly, the only chance to take money from the stock market is for investors to be somewhat different from others since the majority must be wrong and success can come only from doing the opposite from what the crowd is doing.
“It is a simple process of reasoning to prove that the majority of us must always be wrong in the market and are certain to lose. To begin with, we know that to gain profit one must buy when prices are comparatively low and sell when prices are higher. But if most people had the foresight to take advantage of low prices and buy, then the low prices wouldn’t exist since there would then be more buyers than sellers. Likewise, if the majority of us were cagey enough to sell the instant that stocks are priced beyond their worth, then peak prices would never be reached. In short, if everybody were truly intelligent, no one would sell too cheaply or pay too much, and the result would be that the wide swings in prices could not occur. Price ranges would be confined to such narrow limits that no speculator would pay much attention to the market. There wouldn’t be a market! Speculation can be worthwhile only when a few are taking advantage of the stupidity of the many,” he said.
(Disclaimer: This article is based on Fred Kelly’s book Why You Win or Lose: The Psychology of Speculation
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