Some people believe markets are always efficient. They reckon the market knows all there is to know about a stock – and so stocks always trade at their fair value. For these people, it’s impossible to beat the market.
I say that’s rubbish. There are always pricing anomalies and inefficiencies that can create opportunities to profit. That’s what I’m on the hunt for here at The Right Side.
That’s why I like contrarian investors. To them there’s no such thing as an efficient market. And on Friday we looked at how they aim to take advantage of the markets by doing the precise opposite of what others do.
One of the smart things about contrarians is the way they use ‘phased buying’.
Rather than putting their money down in one lump, a contrarian tends to build a position in phases.
Today I want to look at why this is a great idea, whatever type of investor you are. I’ll show you three ways you can phase your investments.
How to avoid buying at the top
The idea of building your position over time certainly isn’t limited to our contrarian friends. When I worked in professional fund management it was commonplace.
And with today’s on-line trading and ultra-low commission rates, this strategy is no longer the privilege of City professionals.
Every week, month, or whatever timeframe you chose, you buy a tranche of the stock you want. You build a position gradually which means that you’ll never end up buying at the top.
Instead you get an average price over whatever timeframe you’re using. It’s often called ‘pound cost averaging‘ and it’s a useful strategy. Instead of buying five thousand shares at £1, you’re better off buying five lots of one thousand shares over say five weeks.
The idea is that you get more shares for your money when the stock is cheap.
Here’s how it works…
| Week | Price | No. of shares bought |
|---|---|---|
| 1 | £1.00 | 1,000 |
| 2 | £0.95 | 1,053 |
| 3 | £1.10 | 909 |
| 4 | £1.15 | 870 |
| 5 | £0.80 | 1,250 |
| £1.00 | 5,081 |
As you can see, over the five weeks the average price of the shares is £1. But by phasing your entry, you end up with 5,081 shares rather than a mere 5,000 (ie 5,000 shares at a pound) if you’d bought on day one.
Of course, in reality the average share price over the period is unlikely to be the same as the share price on day one. Nonetheless it’s a useful concept and I’m a big fan of entering and exiting positions in phases.
But the contrarian investor has even more reason to bide his time when building a position.
To hell with the market – this is a bargain!
What you’ve got to remember about the contrarian is that he’s taking on the market. A contrarian assumes the market is often wrong. And he knows the market can stay wrong a long time.
As he opens his position, he’ll relish the thought of buying more stock even cheaper – he half expects the stock to go down!
And that’s why he’ll buy all the way down. Here’s the second trick you can use to phase your investments.
Let’s say your initial entry point is £1. You can then set limit orders at 80p, 60p and 40p which means your broker will execute new buy orders if the stock falls to those prices.
And wow… those late orders really make good if you’re right. You may have to wait a while – but you could make hundreds of percent gains on the late orders as the market turns in your favour over the long-haul.
This strategy may sound foolhardy. But just remember, a contrarian does his homework. He’s looking for the big thing that nobody else sees. And it’s this third approach to phasing where the contrarian really shows his mettle…
Why contrarians love a bit of bad news
As we’ve just seen, if you’re building a stock position you can use time-frames or price-points to phase your entry.
But perhaps the most important way to phase in is news flow. There’s nothing like news to make a stock move. Especially when it’s bad news.
And seeing as the contrarian is sceptical about how markets work – he just loves to watch the news and buy as the market overreacts.
You see a stock on the rise tends to build momentum over time. Like piling buckets of sand one on top of the other, it builds in a neat pile – right up until there’s a landslide.
Stocks tend to go upwards rather neatly, but crash haphazardly and without warning.
And contrarians love it.
When bad news hits and bids disappear – in other words, buyers dry up – a crash happens suddenly. And a contrarian that knows his business will lap it up – he puts in his bids for the stock. He has scant regard for the market.
What the contrarian is really looking for is a stock hit by bad news that’s unlikely to recur. Even if the bad news wipes out a whole year’s earnings, it doesn’t matter. So long as the underlying business is strong, then time can be a great healer.
A string of profits warnings will hammer a share price down. When it gets so low that there’s little news flow left that can push it lower, you’ll find the contrarians circling.
In my opinion, contrarian investing is the best way to make money from stocks over the long-term.
If you have the patience and the tenacity to take on the market, then rich rewards may be on offer.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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