The Psychology of Investing

The Imp of the Perverse is a short story by Edgar Allan Poe, published in 1845, that explores the subconscious desires of people to do exactly what they should not.  I read it in college, and have no desire to read it again. But the title has stuck with me, and I bring it up today because Poe was a pioneer of psychological thought—and psychology is a critical component of investing, for better or worse.

Imp of the Perverse by Arthur RackhamThe name of this blog, remember, is Contrary Opinion. It’s named that because doing the opposite of the crowd at market extremes is a highly profitable strategy, though devilishly difficult to execute. Contrarily, following the crowd, while wondrously comfortable, is a sure road to mediocre performance, at best.

But it’s not enough to act contrarily all the time, because in the middle of trends, the crowd is actually right. It’s only at the end of trends, when emotions and perceptions reach a fever pitch of optimism or pessimism, that it pays to act contrarily. So listening to the Imp of the Perverse, who is constantly telling you to do the socially wrong thing, is not a successful strategy. Instead, it’s best to take a sober measure of the crowd’s temperature continuously, and act only when maximum emotions are observed—and then only if the charts confirm your judgment.

For example, back in late 2008, when the subprime mortgage crisis brought down first the entire housing industry and then the entire U.S. economy, negative sentiments reached extreme levels.  And through the winter of 2008-2009, sentiment remained terrible. But when the stock market began advancing in the spring of 2009, that strength was a great buy signal, even though the fundamental news (and sentiment) was still terrible.

More recently, in 20012, Apple (AAPL) was a darling of investors (who had profits) and consumers (who loved the company’s products). But AAPL was so popular that at the peak in 2012, there were no more potential buyers of the stock; everyone who could buy had already bought! Which meant there was a preponderance of potential sellers! So when AAPL actually turned down in late 2012, it was great sell signal. Within seven months, America’s most loved company saw its stock fall 45%!

Today, investors as a whole are rather bullish about the market, because they’ve enjoyed good profits this year, but the man on the street is still not invested, so I can’t say that sentiment is particularly high. Contrary opinion is not always useful.

But it is interesting to note that Apple (AAPL) remains one of the most popular stocks among users of stockcharts.com. And that tells me that the stock is still far too popular to be a good buy. In fact, it reminds me that one of the handicaps people have when it comes to investing is their inability to see enough options.

They think, “Apple. It’s a good company, and its stock is down from 700 to 520, so it’s probably a good buy.” But these people have no system, aside from the system that works outside the market—buying things cheap is usually good—and worse, they have no idea that there are thousands of other stocks worth considering, stocks of companies that aren’t as well known as Apple.

What you really need to look for in a growth stock is a company that’s growing fast but is not yet universally known and is not yet well respected by most people. If you have these conditions, you have more potential buyers than sellers—and if the stock is going up, you have conditions that will likely attract more buyers soon, to fuel the uptrend.

For example, Tractor Supply Company (TSCO) is not as big or as well known as Home Depot. But it runs 1,245 stores in 47 states, serving the “lifestyle needs of recreational farmers and ranchers.  The Company also serves the maintenance needs of those who enjoy the rural lifestyle, as well as tradesmen and small businesses.  Stores are located in towns outlying major metropolitan markets and in rural communities.  The Company offers the following comprehensive selection of merchandise: (1) equine, pet and small animal products, including items necessary for their health, care, growth and containment; (2) hardware, truck, towing and tool products; (3) seasonal products, including lawn and garden items, power equipment, gifts and toys; (4) maintenance products for agricultural and rural use; and (5) work/recreational clothing and footwear.”

I like TSCO because it’s growing, and can grow more just by opening more stores. I like it because it’s not well known. And I like it because the stock is going up.

But if you invest in TSCO, particularly if you’re a city dweller, you’ll get little or no social reinforcement of your decision, and that can make it psychologically difficult. Nevertheless, it’s a truism that the best investment decisions are the ones that make you uncomfortable. Think about it. And if you want more expert advice, head over to cabot.net.

 

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>