For many people, it’s difficult to un-learn the schoolyard lesson that “fitting in” is the best thing to do. But if you want to be a successful investor, it’s a critical skill.
Contrarian investing involves buying when everyone is selling and selling when everyone is buying. It has been around as long as people wanted things others had and has made fortunes for legends from Baron Rothschild to Warren Buffett to Jim Rogers. They went against the crowd and bought assets that were oversold. Or they shorted securities and waited for their price to decline. (Shorting is a way to profit when the price of an asset declines).
This strategy usually works because of “mean reversion.” A mean is a way of averaging. It is what you get when you total all the numbers and divide that by the number of things counted.
In mean reversion, then, extreme, random events may take you one way – but then they usually return to normal, or the average, over time.
For example, record cold temperatures sooner or later give way to average temperatures. Your favourite team wins five games in a row, but then loses a few after that. If you have had a terrible couple of days, the next few likely will be better. These are all “mean reversion.”
In investing, extreme prices move up or down and return to their average like a rubber band. Stretch it and when you let go it returns to its original shape. That is mean reversion, and it works over short and long periods.
As with many market forces, mean reversion depends on the irrationality of investors. As we’ve discussed in recent months, many biases contribute to impulsive investment decisions. Such involuntary behaviours are left over from humanity’s distant past, when acting first and asking questions later – for example, to avoid becoming a predator’s dinner – was a crucial survival skill.
“Availability bias” is central to mean reversion. This is the tendency of investors to pay too much attention to new or easily remembered information when making investment decisions.
We are hardwired to evaluate risk at the “gut” level, rather than use our brains and process it logically.
Unfortunately for investors, that means we are suckers for vivid stories from the recent past, giving them lots of emotional weight. Warren Buffett’s advice is: “Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”
The availability bias is powerful; you have to “close the doors” to avoid being influenced by it.
A classic example was the Ebola virus scare from the fall of 2014. Only a handful of Ebola cases were reported outside of Africa, and health experts rated the chances of an Ebola epidemic elsewhere as very remote. Despite that, investors around the world panicked. Vivid images of dying Africans, nurses in full hazmat gear – coupled with sensational media coverage – caused stock prices to fall. In turn, that seemed to legitimize a high Ebola risk.
Media hysteria and falling stock markets fed on each other. Below is a chart overlaying Google searches for the phrase “Ebola” on top of the VIX Index. (This index measures the premiums of put options on the S&P 500. When investors are worried that the market will fall, they buy put options to profit if it does. As they buy more, the premiums go up. That’s why it’s called the “fear index”). A spike in global interest in Ebola coincided with a spike in investor fear.
Airline stocks were hit particularly hard because investors seemed to think Ebola would forever change the nature of air travel. It didn’t, of course. The next chart shows Delta Airlines (DAL) shares declining over 20 percent in the three weeks prior to the panic lows.
Investors easily could have researched the facts of Ebola and even studied what happened to markets in past epidemic panics. They would have seen that shares always bounce back higher after the level of fear declines. Instead, investors suffering availability bias ignored logic and joined the panic.
Seasoned contrarian investors logically assessed the Ebola scare, avoided the availability bias and got greedy while others were fearful (as Warren Buffet recommends). They profited when markets “reverted to the mean,” and became normal again. That panic and the mean reversion that followed was a short-term event; it only took weeks to play out.
Mean reversion is also evident in the long-term behaviour of stocks and other markets. Many studies have shown that major asset classes experience extreme price moves higher or lower than the long-term averages for months or years before they revert to “normal.”
Below is a daily price chart of oil. Currently at US$33, WTI’s 200-day moving average is at US$44, the average price over the past 200 days. It’s unusual for the price of oil not to touch its 200-day average occasionally, so oil prices could be a candidate for a reversion to the mean and go back up for gas buyers and investors.
Contrarian investing based on mean reversion is not without risks. A stock may continue to “trend,” or keep moving in the same direction, as oil has. During such events, businesses go bankrupt, driving their stock price to zero, never to revert to its average price. That is the worst-case scenario for investors in stocks.
With that in mind, here’s what an investor can do to be a contrarian and profit from mean reversion:
- Study the fundamentals. Mean reversion opportunities are found in market prices that move too far below or above the average. The average could change depending on business conditions. For a significant (and not just a short-lived), price correction to occur, underlying business realities also must revert to average from extreme levels.
- With oil, for example, prices fell from US$100 to US$30 in 18 months as world markets drowned in excess oil. Are those setting the stage for a mean reversion back to what used to be normal?
- Determine what extreme prices looked like historically. Study a chart of instances when a price went well beyond its long-term moving average. Oil is about 25 percent below its 200-day moving average, the largest amount in history.
- Look at how extreme investor sentiment can be. The more extreme, the better. Oil also has a VIX “fear index” (the OVX) that tracks what options traders are doing in the oil market (below).
- Recently, we saw a spike in the OVX as oil traders rushed to buy put option “insurance” against oil prices falling even further. Fear, a necessary ingredient for mean reversion, is in place, as the chart below indicates.
- Think of a catalyst that could change investor outlook and their availability bias. Oil prices have been falling for over a year, yet producers keep producing the same amount of oil the market has demonstrated it does not need. What might cause that to change?
- Protect yourself. When you pull the trigger and enter the trade, make sure you enter a trailing stop. Ensure that you will survive to invest another day.
Mean reversion will help you avoid getting overly excited when prices keep going up, and will keep you from running away when they fall. Remember that eventually, things get back to average.