Emotions such as hope and fear often lead investors toward irrational decisions which create pricing inefficiencies in the market. During peak optimism and pessimism, valuation and fundamentals are replaced by hype or fear. The herd often makes decisions based on emotion, buying “high flyers” at outrageous prices and selling “down and out” stocks at rock-bottom prices.
We do not get caught up in fads, overly optimistic growth projections, or dire gloom and doom predictions. We remain objective and tune out the psychological blabber. We dig deep with sound research to uncover investment opportunities created by extremes in investor psychology (our Q1 2009 Newsletter is one example of this thinking at work).
- Our studies of investor psychology show that stocks hit their lows when the prevailing opinion is “things are bad and they are going to get worse.” While emotionally difficult to implement, we look to keep our cool and benefit from investor overreaction by buying when pessimism has peaked.
- Contrarian investing uses the idea that stocks hit their lows when people are most pessimistic. Since investors are looking to “buy low and sell high,” contrarians are looking to buy when the prevailing opinion is pessimistic and sell when sentiment inevitably swings back to optimism.
- While buying out-of-favor companies has produced stellar returns, buying stocks clouded by outright fear have done even better. Crises often present outstanding opportunities to profit, because investor overreaction at its wildest. In a crisis or panic, the typical guidelines of value often disappear and people no longer examine what a stock is worth. By remaining objective, contrarian investors can profit by going against the crowd.