When to bet against the market

"The market's got it wrong."Whenever I hear those words, a shiver goes down my spine.

It immediately takes me back to a brutal lesson I learned early on as an investor. At the time I was convinced that the market was taking one of its regular departures from reality. I was sure that investors were getting swept along in panic. And I would make a small killing once they saw the error of their ways.

Big mistake - I got badly bruised. But I bet the very same thing has happened to you at some stage.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The truth is that we all believe that we can outsmart the market at one point or another. It's in our nature. Psychologists say that we are simply hard wired to overestimate our abilities.

But this can be a fatal flaw for an investor. And today, I want to tackle this issue head on. I've been spurred on by some of the great responses to last week's Right Side on investment mistakes.

And I thought the best place to start a series on investing mistakes was with the first hard lesson I learned - never blithely assume the market is wrong.

I'll also explain how I now use two simple tools to work out when to bet against the market. I hope you find these useful.

Is the market ever wrong?

There is no doubt in my mind that the markets often get it wrong. After all, the market price is just a reflection of consensus opinion. And you can never put your trust in that.

Only two years ago the consensus told us that lending money to the Greek government was almost as safe as lending to the Germans. Boy, was the market wrong about that one.

But, if you choose to bet against the market, you should be ready to have your nerve tested. Even if you're right in the end, you may have to suffer losses first. This can shake you out of your position. If not by knocking out stop losses, then by making you question the trade and closing out too soon.

It's a lesson I learned the hard way myself.

My first kamikaze moment

Last week I mentioned that I'd taken a bruising from the crash of 1987. I didn't actually lose too much on black Monday - as I'd cashed in a lot of my investments ready to punt it on the upcoming BP flotation.

What really cost me was trying to fight the market in the days after the crash. As a 15 year-old I thought that the market had got it wrong and somehow I knew better. That's the arrogance of youth I suppose.

After the initial crash, I was convinced that loads of my favourite shares were now cheap. I bought back in at what looked like knock-down prices.

October 1987 crash

One week later, and five grand lighter, I got shaken out. I couldn't take the pain anymore. It turns out that I'd been suckered in by a dead-cat bounce'.

I learned the hard way to never blithely assume the market's got it wrong.

So when can you bet against the market?

George Soros puts it well. Find the false premise and bet against it.

The key to true contrarianism is to understand why the market is pricing assets as it is and then to identify the market's false premise. First, you have to know what the market is missing - why the consensus is wrong. And secondly, you need to know the trigger that's going to change the markets opinion.

As I punted on those shares back in 1987, I had neither a false premise, nor a trigger event in mind.

My trades were ill conceived. The upshot was that there was no evidence to support my trading. It was plain gambling.

Let's look at one of my open trades today. I want to show you what I mean by the false premise and the trigger.

Your FREE oil report: The 3 best ways to play the coming oil supply crunch right now!

• Discover how to profit from oil without ever owning a single barrel
• Why NOW is the best time to put a few carefully selected oil investments into your portfolio

Should we sell out of Gold?

The false premise: paper cash is a dependable store of wealth and the financial system can always be patched up by central banks and politicians.

Triggers: a double dip recession, or another bout of bank losses, or a loss of faith in international financial markets.

Any one (or all) of these triggers could cause the central banks to push their luck too far with their experimental money printing. If faith in paper evaporates, gold could fly as cash heads for the safety of the yellow stuff.

So long as I see evidence that central bankers and politicians really don't understand that they're playing with fire, I'm happy to bet against the consensus. In short, I can see a false premise.

And I've got three potential triggers in mind that could cause the market to change its opinion.

Remember, identifying a false premise isn't enough. To make a profit, there has to be a trigger for the market to realise its mistake.

In 1987 as it turned out I was probably right - markets did rebound shortly after the crash. But because I didn't see the false premise and I didn't see any triggers, it didn't take long for me to get shaken out of my positions.

Today when I go against the market, I put in place enough slack to cover markets irrationality' continuing. And I keep a constant eye on the false premise and triggers.

Over the next few weeks I'll be returning to the hardest lessons I've learned. And I'll pass on a few simple measures for avoiding the worst mistakes as I go.

This article was first published in the free investment email The Right side. Sign up to TheRightSide here.

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Past performance and forecasts are not reliable indicators of future results. Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do