CHAPTER 1
Your Brain-Training Guide

Few truths are self-evident, but here's one as close as they get: In investing, the crowd is wrong much more often than right.

Most folks accept this. They remember pain from some of their own mistakes. More so, they recall market-bloodied friends, relatives, neighbors and co-workers. They've seen all the famous market gurus get egg on their faces. Academic studies show the wisdom of the investing crowd is folly.

Yet folks follow along anyway. For most, it's impossible not to! The financial blogosphere, websites and cable TV talking heads pound market groupthink into our brains 24/7. Without conditioning yourself to resist, it's all too easy to accept repeated falsehoods as fact, melt into the crowd and buy high, sell low-with the rest.

There is another way! Train your brain to battle the media, the crowd, your friends, neighbors and cocktail bankers and think differently. It doesn't take vast market knowledge, a finance degree, an economics PhD or endless rigorous study. Armed with a few basic principles, internal alarm bells and an instinct for independent thought, you can be a true crowd-beating contrarian investor.

Yogi Berra once quipped, "Baseball is 90% mental, the other half is physical." Might apply to investing! Mental discipline is key to success. See this book as your brain-training guide. You'll learn tricks you need to protect your brain from media hyperbole and some principles to outsmart the crowd.

What does being a contrarian mean? What's the secret to being right more than wrong? Prepare to find out. In this chapter, we'll start with the basics:

• Why Wall Street's definition of a contrarian investor is wrong
• The foolishness of conventional wisdom
• The true contrarian's gut-check

Wall Street's Contrarian Contradiction

Legend lumps all investors into two categories: bulls and bears. Those who think stocks will rise, and those who think stocks will fall. If the masses are bullish, Wall Street says anyone who's bearish is a contrarian. If the masses are bearish, bulls are the contrarians.

But this is wrong. It implies "everyone"-one big crowd who thinks stocks will do one thing-and "everyone else," another crowd thinking stocks will do the opposite. "Everyone else" often thinks they're contrarian. They think "everyone" is the herd, and the herd is always dead wrong. They've seen the countless academic studies showing the majority of investors are just terrible at making investment decisions, usually selling low and buying high. They believe doing the opposite of the crowd guarantees buying low and selling high.

Problem is, "everyone else" is as crowd-like as "everyone." Their opinions usually aren't unique, and their analysis often isn't any broader or better than the main crowd's. They look at all the same things, just with a dissenting, condescending sneer. People thinking this way and that they're contrarians aren't any smarter, any more discerning than you or me or the crowd. Their moves rarely pay off any better.

That's the bad news. Here's the good news: You can be a real contrarian! Once you know what leads the crowd or both crowds astray, it isn't hard to think better and act smarter. It's impossible to be perfect, but to be better than most isn't so hard.

The Curmudgeon's Conundrum

Two-herd contrarians see the world like an analog clock. They base bets on wherever the main herd expects the hand to land. If everyone says the clock will point at 1, the supposed contrarian herd bets it'll land on 7-roughly the mirror opposite direction. Just because it's the opposite! Contrary for contrary's sake. Much of the time, no real extra thought goes into it. Just a curmudgeonly instinct. "Everyone's cheery, so I can't be." It wouldn't occur to curmudgeons to consider other alternatives, like "Everyone's cheery, but maybe they should be even more so!" This isn't physics, where for every action there is an equal and opposite reaction. Assessing markets and events based on a false either/or could lead to big mistakes when you consider results are not binary.

Transferring our clock metaphor to stocks, if the crowd thinks stocks will rise 10% in a year, the curmudgeons bet on down. Perhaps not down 10% exactly-they'll bet on the opposite direction, but they might not bother guessing the magnitude. Their nature is to be ornery, but not ornery with precision. Simply betting the reverse direction is good enough for them.

We can transfer it to a recent scenario, too, like the Federal Reserve's quantitative easing (QE). The crowd thinks QE is good, propping up stocks. Contrarians think it's bad, risking inflation. Here is your false either/or! In my view, QE is bad because it is deflationary, an outcome neither the crowd nor the supposed contrarians consider. There is a century of economic theory and research supporting this notion, but the crowd buys the common narrative, which crowd-contrarians are so fast to categorically reject that they miss the truly big problem with crowd-think. There, too, they're just being an opposite crowd without much deep thought. (More on QE later.)

What's the problem? A clock doesn't have just two numbers! It has 12 hours, with 60 minutes in between. Even if the masses bet wrong, the curmudgeon has a 10-in-11 chance of being wrong, too. That's a 1-in-11 chance of being right. Same goes with markets. If everyone calls for a 10% year, stocks need not end down for them to be wrong. Flat returns would do it. So would up 20%, 30% or more, because most who envisioned 10% would have sold out by the time stocks hit 15%. The curmudgeons who bet on down could very easily be wrong-and often are. Not that being wrong would hurt if you called for 10% and stocks did 30%, if your positioning was right and you didn't sell too soon, but we'll get to that in Chapter 2.

There Is Always a But

The market is The Great Humiliator. TGH for short. Its goal is to humiliate as many people as possible as often as possible for as long as possible. Preying on the herd is its bread and butter-humiliates a whole bunch of investors at once! The crowd is the easy, typical prey, but TGH spares no one forever. Even true contrarians get whacked.

No approach works all the time, including assuming the crowd is wrong. Sometimes, they're right! The market usually doesn't do what everyone expects, but there are always exceptions. If TGH didn't let the crowd be right sometimes, there wouldn't be a crowd! Momentum investors-those whose guiding principle is "The trend is your friend"-would be proven wrong the moment they invest. Markets would slap most folks in the face as soon as they buy-or sell-and people would learn from their mistakes. Stocks wouldn't have anyone to fool, and fooling folks is one of the market's greatest pleasures.

People must be right sometimes, must feel good sometimes, or we'd never have a herd. They would just give up. The occasional rightness fosters false confidence, reinforcing the crowd's wisdom. It is plausible deniability for TGH. It is how TGH repeatedly sucks the crowd in, makes them ignore negatives, then doles out maximum pain and suffering. (TGH probably then enjoys a cartoon-villain-like laugh.) This is why seasonal myths like "Sell in May" and "September is the worst month" ring true. Even though they're wrong more often than not, they're right sometimes. Those times when May, summer and September returns look sad, coupled with below-average historical returns for May through September, keep the myth alive. Occasional and often dramatic rightness gives myths power.

Markets often let the crowd look right temporarily, before turning on them. Folks who believed the eurozone crisis would end the bull market in 2011 looked awfully right that October, when world stocks were at the bottom of a deep correction. But stocks bounced and the bull carried on in 2012, 2013 and beyond, shrugging off history's largest sovereign default in Greece along the way, ultimately proving the euro doom-mongers wrong (or very untimely, also effectively wrong).

Sometimes, markets' wobbles let folks think they're right, like when a correction comes after headlines warn some big evil will rock stocks. Corrections-sharp drops of -10% to -20% over a few weeks or months-come any time, for any reason or even no reason. But fear-mongers often assume conveniently timed corrections are proof that whatever they warned about was as big and bad as they said. This isn't fundamental rightness-just confirmation bias (seeing what you want to see), a dangerous behavioral phenomenon, but most folks don't bother differentiating between fundamental rightness and happenstance. (More on this in Chapter 9.)

Just as the crowd is sometimes right, true contrarians are sometimes wrong. Everyone is wrong sometimes! The goal is simply being...