Crowd Behavior and the Concept of Contrary Opinion

The art of contrary thinking may be stated simply: thrust your thoughts out of a rut. In a word, be a nonconformist when using your mind.

Sameness of thinking is a natural attribute. So you must expect to practice a little to get into the habit of throwing your mind into directions that are opposite to the obvious.

Obvious thinking—or thinking the same way in which everyone else is thinking— commonly leads to wrong judgments and wrong conclusions.

Let me give you an easily remembered epigram to sum up this thought:

When everyone thinks alike, everyone is likely to be wrong. (Neill, 1997, p. 1)

When individuals think by themselves, they can be logical and reasonable, but when joined with a crowd, they tend to let certain cognitive biases affect their decision making. History is replete with examples of financial manias—those periods when, in retrospect, the crowd of investors became overly irrational. During those periods, the irrationality is met with a new hysteria, the belief that “things are different this time.” We have seen this emotional excess just recently in the Internet stock-price bubble in the late 1990s and in the real estate bubble in the early 2000s. At those times, it was difficult to argue, much less invest, against the prevailing trend of emotion. Too many were making too much money regardless of their reasoning. Of course, such times eventually reverse and return to normal and often decline to an opposite excess. Not believing that they are personally caught in a mania, when prices reverse, people blame others for their own irrationality. Denying their own responsibility for being duped by the emotions of the crowd, they demand new laws be passed to prevent “evil” corporations or government laxity or fads as derivatives from causing another bubble. Such behavior is not limited to financial markets. Manias occur in politics, religion, philosophy, education—almost every human endeavor. They are often man-made, as in either the Tulip Bulb mania or as in politics through propaganda and “spin.” The Theory of Contrary Opinion is an attempt to teach individuals how to recognize and profit from such excesses in emotional fervor and to look at all sides of a belief before committing to it or rejecting it.

A “crowd” thinks with its heart (that is, is influenced by emotions) while an individual thinks with his brain. (Neill, 1997, p. 3)

Contrary opinion is a “way of thinking…. It is more of an antidote to general forecasting than a system for forecasting. In a few words, it is a thinking tool, not a crystal ball” (Neill, 1997, p. 9). To be a contrarian, an investor must sell (be pessimistic) when the overall market mood is grossly optimistic and buy (be optimistic) when most investors are pessimistic and in a panic. Although this might sound easy enough, the problem with implementing a contrarian strategy is that it is indefinite. Remember that one of the basic tenets of Dow Theory is that prices trend. When prices are trending upward, we want to be in a long position, riding the trend. The goal of understanding sentiment is to discern when that trend is losing energy and will reverse. Therefore, the task of the contrarian player is to find a way in which to quantify which direction the majority of market players is headed and to question whether there is enough remaining energy to keep the market moving in that direction. Remember that so long as players still have money to invest in the market, their optimism will drive prices higher. It is only when players are fully invested that their optimism will not be accompanied by security purchases. At this point, the market is at an excess, and the trend often ends. To quantify these excesses, the technical analyst uses publicly available data to construct indicators of emotional excess. Now that we have looked at some of the theoretical underpinnings, let us look at how these sentiment indicators are typically constructed and evaluated.

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.