Being contrarian may be difficult, but falling prey to herd behaviour and groupthink can also carry risks.
You might feel more confident investing in a company that more analysts like (e.g., a company that has more buy than hold ratings). But, as a new report from Richardson GMP points out, “Companies with fewer buy ratings tend to outperform those with the most buy ratings.”
The report also notes that while “it is more stressful investing in companies that nobody likes,” it can be “cheaper to bet against the herd.” This can be seen most clearly, it adds, in the futures/options markets.
For example, “If the demand to be long a given stock is pervasive, the cost of carrying a short position will be lower. When markets are doing well, the cost of portfolio insurance is often the lowest. Conversely when participants become fearful, portfolio insurance ends up costing materially more.”
But betting against markets isn’t easy, the report says.
You need to be knowledgeable about the pros and cons of instruments like derivatives. “We would encourage investors to be cognizant of extreme levels in the futures market” since that can lead to “potential changes in direction of the underlying asset” of a futures contract. Extreme levels can also indicate that “a trade has become very crowded,” the report says. Read the full report.
Further, not everyone can handle the stress of strategic investing nor are they financially fit do so. One of the keys to success with clients is figuring out what they can handle from an investment point of view as well as keeping up-to-date on their emotional well-being — you should also be aware of your own biases and limits.
Overall, it’s best if your clients strive to honest with you about their market reactions rather than try to impress you with how unemotional they can be.
For more on how to assess clients behaviourally, read: