You may have heard about the “madness of the crowds” and the idea that 90% of amateur investors are on the wrong side of the trade at any given moment. There’s certainly some merit to that idea, but contrarianism can be taken too far and this can inhibit your long-term results.

A common reason that people choose contrarian investing is because they’ve heard about the amazing results of legendary value investors like Warren Buffett, Charlie Munger, and Benjamin Graham. And indeed, their willingness to buy what most stock traders are selling has been crucial to their success.

Another reason some people gravitate toward contrarianism is because they were just born with a general distrust of crowds and groupthink. If you feel that most people are wrong most of the time, and/or people generally have no idea what they’re doing, then adopting a contrarian investment approach is only natural.

Here’s where all of this can become problematic. Sometimes, the crowd happens to be right. For instance, the dot-com bubble burst after a while, but the internet did become a permanent part of the fabric of society.

Another example would be this year’s mad rush into AI stocks. Sure, NVIDIA stock has been overbought since January, but anyone who short-sold it lost their shirt. The same thing could be said about Tesla stock, which seemed overvalued years ago – yet, the company is an automotive giant today that rivals Ford and General Motors, and Tesla’s shareholders have enjoyed tremendous returns.

Courtesy: @JeffWeniger

On a long-term basis, following the crowd has turned out reasonably well for stock investors. The bull markets have been prolonged and powerful, while the bear markets have been relatively short and shallow.

Thus, simply riding along with the majority of stock traders has usually been profitable, especially for investors who diversified their holdings. Much of this can be attributed to the nature of auctions, which is what the stock market really is. In any auction, once buying activity starts to pick up, prices can soar surprisingly quickly.

This is why short-selling stocks, even when their prices aren’t justified, is rarely a good idea. As the old saying goes, the market can remain irrational longer than you can remain solvent.

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    Even when the crowd isn’t “right,” it can simply force asset prices higher for an absurdly long time. Some commentators claim that it’s too late to buy a stock if it’s featured on the front page of the mainstream media. However, there’s typically a final share-price boost – or even several final boosts – as the latecomers, the FOMO crowd, and the bandwagon jumpers push the price up to new heights.

    This is what we saw with AMD, the darling of the market earlier this year, and now we’re seeing it with NVIDIA. Nowadays, a CEO only needs to mention AI and LLMs multiple times in a conference call, and the share price magically levitates.

    Courtesy: St. Louis Fed

    As soon as you think that a stock’s price shouldn’t or can’t go any higher, more “dumb money” comes off of the sidelines and into the irrational market. There’s plenty of money ready to be deployed, and I don’t recommend trying to outsmart the “dumb” crowds.

    If you look at their actual investments, you’ll see that Warren Buffett and Charlie Munger don’t always do the opposite of what the crowd is doing. An example is Buffett’s investment in Apple stock, as you’d be hard-pressed to call Apple an unpopular company.

    It’s probably more accurate to call Buffett an independent thinker instead of a contrarian. He uses a combination of research and instinct to determine a company’s true, intrinsic value. If there’s a mismatch between that value and the company’s market cap, then there may be a buying opportunity.

    In assessing a company’s value this way, Buffett doesn’t require the confirmation or approval of the crowd. But then, he also doesn’t feel the need to contradict the crowd at every opportunity.

    Thus, independent thinkers march to the beat of their own drum, and the results can be phenomenal if the principles are applied correctly. Contrarian investing and value investing may overlap sometimes, but we shouldn’t consider them to be one and the same.

    In the end, independent thinkers can peacefully co-exist with the irrational crowds and the price chasers. Let them do their thing while you do yours – and if the crowds happen to carry your stocks to new heights, you can thank them for their reckless behavior.

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