How to Beat the Herd by Being a Contrarian Investor

Ok so most of you already know that the average investor makes about the market average or below returns per year. If this is something that you are satisfied with, that’s fine! If you want more (I sure do), then read along.

In this article I’m going to introduce to you a concept called contrarian investing and how I personally do it to reach market beating average returns (quick hint: I use Etoro).

People  tend to act like sheep, they subconsciously follow everybody else. If everyone is buying a stock, then so should I, they think. A great contributor to this is the fear of missing out emotion.

Doing things in a herd is a primal survival instinct that has helped us stay alive back in the stone age. Nowadays being in a group of people still feels more secure and I get it, but when it comes to investing or trading, you really need to separate yourself from the crowd to yield above average returns.

Contrarian investing

The simplest way to explain the concept is that it means buying the stocks/currencies etc that everybody else is selling and selling the ones that everybody else is buying.

Why does it work? 

It works, because according to theory, if majority of the traders are long a stock, there is no one left to go long. All that traders could do is hold on to it or sell it. So the upside potential is slim and has diminished.

It works vice versa as well, if you know that the majority of traders are short a currency pair or a stock, you should do the opposite and buy it, because there is no one left to short it. Most people are already short and if the price won’t fall further, they will start exiting their trades, which will rather often yield a rise in the price.

How to put it into action

The only way you can use it if you somehow are able to realistically know what the majority of the traders are doing. It doesn’t work if you only know what the majority is thinking, you also need to know how they have invested. This is really important, as people often don’t practice what they preach.

One simple way to know the overall sentiment of the market is to check Yahoo Finance’s “short interest”. This is a number that tells you how many people are short the instrument. If you see that the number is high, you could initiate a long position.

Yahoo finance indicator is a neat tool, but it won’t actually help you too much. It is updated not too often and you will only know the short interest, while having no idea how many people are long the stock.

A much better tool for this is the Etoro social sentiment indicator. What it does is show you how many of their users are long or short the currency pair, stock or commodity. This is vital information. If you know that 90% of people are long, you could take a short position and expect the price to fall, as there aren’t too many people left to buy it.

Etoro has over 5 million users so their user based sentiment is rather indicative of the sentiment of the overall market.

I will post a more thorough article on how to do this step-by-step.

But for now, I encourage you to look into the concept of contrarian investing and recognise the power of separating yourself from the herd.