Contrarian investing is often considered as a long-term opportunity.
The word contrarian essentially means bucking the trend, taking a contrarian viewpoint.
It means your investment strategy is radically different.
It is mainly an outcome of the deep-set concepts about crowd behavior in the market.
According to this, investors often take a decision as a group.
The contrarian goes against this conventional wisdom.
The idea is that herd movement often leads to mispricing of securities.
The contrarian investor seeks to capitalize on that opportunity.
This is exactly why the gains in this strategy are always long-term.
You cannot have a sudden or immediate price correction.
Definition of Contrarian Investing
How would you define contrarian investing?
In very simple terms, it is going against the market trend.
Then, you wait for the right opportunity and sell when the stock prices escalate.
A common belief is that the market is driven by buyers and sellers.
When the buyers exhaust their buying power, they say that the market will rise.
This is because they are completely invested, and price escalation is the only way to get value.
You can assume that this will be pretty much close to the market peak.
Now once they have sold their positions at significant gains, they predict a fall.
Essentially then it is dictated by group force and simple demand-supply fundamentals.
This, therefore, explains the disparity between the price movement and volatility index.
That is why it is such an important tool for the contrarian investors.
You are predominantly going against the core beliefs in the market.
Therefore, you need a strong alibi.
This index becomes a reflection of their core belief.
As a result, when securities correct, the rate of return is much higher.
So, does it mean a contrarian investor is a bear?
Well, not necessarily but they sure spice up their investment with some caution.
Cardinal Concept of Contrarian Theory
The foundation of cardinal investment is a fundamental trading concept.
If there is considerable pessimism about a stock, it can drive prices very low.
This can even lead to overstating the risk.
The exact opposite happens when there is too much optimism about a stock.
The stock price reaches euphoric levels.
The investors tend to overlook the risk.
But eventually, stock prices correct to fair value levels.
This is where the contrarian investor looks at gaining from the situation.
One of the biggest champions of this investment strategy is Warren Buffett.
The Oracle of Omaha is known for buying stocks at beaten down levels.
He then waits patiently for the stock to appreciate.
In many ways, you can relate this trading strategy to behavioral science.
But, this also involves a deep understanding of market fundamentals.
contrarian investing is not just taking a contrarian view.
You need to understand the scope of gain and loss as well.
So, in many ways, you predict a future outcome and calibrate your investment accordingly.
The entire premise is that group action can severely impact fair price levels.
These trading principles are not limited to stock prices.
You can apply the same theory to sectors, currency and most asset classes.
The only prerequisite is that investors need to value assets accurately.
That is how you can benefit from it.
So, this means that the investor has to study the trend and fundamentals very well.
They use a variety of matrix to assign an appropriate value.
However, the volatility index is a primary indicator for contrarians.
This is a clear indicator of euphoric market conditions or very low valuations.
So, ultimately it is about seeking a value buy.
Drawing Similarities with Value-Based Investment and Contrarian Investing
In fact, there are many similarities between value buying and contrarian investing.
In both cases, investors capitalize on the distinct discrepancies in pricing.
They are both looking for assets that are undervalued in the market.
Their profit is based on ways of deriving value from these undervalued counters.
So, in many ways, both sets of investors going against the market grain.
They are looking beneath the obvious and try to look for intrinsic value.
But there are some fine differences between the two.
Value investors look for value by analyzing the PE ratio of the stock.
Contrarian investors may also look at it.
But most times, the contrarian investors also take note of the market trend.
The market sentiment is also a crucial parameter for contrarian buys.
This is because you are bucking the overall market trend in contrarian investing.
The qualitative importance of the investment call also becomes important in this case.
So in case of contrarian buys, market forecast and analysis are also crucial.
In comparison, value investment is much focused.
The investor is focusing on one specific stock or asset.
The overall market trend is of no interest to them.
They have found an undervalued counter and bet on it.
The perspective of a contrarian investor is significantly wide.
Most times, they do not just take a call on a specific stock, but the overall trend.
Let me explain with an example.
If I am betting that tech sector is going to recover, it is not only about fundamentals of tech stocks.
There are also other related factors.
These include global economic conditions, demand environment and many others.
So, there are many similarities, but value investing is a lot more focused.
The Long-Term Factor of Contrarian Investing
This is why most contrarian investing is betting on future returns.
It is never about instant gains or immediate profit.
contrarian investing generally stretches over a relatively long period.
There is another aspect to it as well, the psychological impact.
This is why there is a long-term element in it.
It is based on the belief that investors tend to overreact.
This would mean that the stock prices are going to correct more than their fair value.
Similarly, even when prices appreciate, they tend to reach euphoric levels.
That coupled with sudden developments result in drastic stock movement.
The contrarian investor capitalizes on this cardinal factor.
This is why they stress a lot about screening stocks appropriately.
That means the contrarian buyer is not just happy with low priced stocks.
It is also important for them to determine how much value these stocks represent.
That alone can help them identify the right counters to capitalize on the market.
So, let’s go back to my example about a bet on tech stocks.
I will not just buy beaten-down tech stocks only because the market is going up.
I will also analyze the earnings in the technology sector.
Sometimes, even Government regulations are relevant in this context.
Then I will also take into consideration the other associated triggers for this sector.
When they all come together, I can think of buying technology at really low levels.
It can represent contrarian value over the longer term in a convincing manner.
Additionally, any investment has to provide sufficient room for safety.
This means that if the trade should have sufficient room to digest any drastic change.
That will provide the necessary cushion in your trade.
This will also give the investor a relative amount of breathing space.
A Disciplined Trading Approach of Contrarian Investing
contrarian investing needs a far more disciplined approach.
Typically investors use a bottom-up approach.
This means that they need to first look for low-value stocks.
Then they invest in companies with low PE, but strong growth prospects.
Moreover, these counters also need to exhibit strong earnings history.
That is by far one of the most telling indicators of good fundamentals.
Also, you need to analyze the downside protection that you have in the stocks.
Normally stocks with low valuations have fairly reasonable downside protection.
Also, compare the relative return compared to the benchmark.
This will help you identify the potential counters effectively.
Perseverance is also extremely important in contrarian investing.
Once you have identified the potential of a stock, you need to position the trade properly.
This will help them to improve the return prospects.
You must remember that consistency is very important in this case.
The lack of a disciplined approach can easily erode returns.
It can even reduce the gain prospects by a significant margin.
Therefore, creating the appropriate focus is cardinal.
You also need to be alert about various geopolitical developments.
They will also have a significant impact on the return prospects.
Advantages of Contrarian Investing
There are many advantages of contrarian investing.
You don’t have to be a perpetual bear in the market.
But it sure helps you lock profit to a considerable extent.
The trick is learning to identify the appropriate counters in a conclusive manner.
1) Don’t Have to Determine Market Direction
This is perhaps the most pronounced advantage.
You are not looking at determining the market direction in any manner.
On an average, it works on the theory that when people are buying a stock at a breakneck pace, it not the right time always.
Moreover, selling when there is overall panic in the market is not appropriate either.
This means you don’t have to determine the overall direction.
You need to simply focus on an undervalued sector or stock and then look at buying specific counters at a specific price.
Your buying is mainly driven by the thought that the panic wave that people are selling at is not right.
The fair value of the stock is a lot higher than current levels.
You just need to be patient to realize the returns in a conclusive manner.
Overall, the quality of the stocks you buy determines your returns.
2) Higher Success Potential
That means a contrarian investing can have better return prospects.
The chances of yielding profit later are relatively higher.
Irrespective of market conditions, you can get a lot higher returns.
So, whether it is bullish markets or bearish conditions, your gains are assured.
You can even hope to get returns in neutral market conditions.
The overall trade has very little correlation with the stock market as a whole.
The performance is not related to the stock market performance as such.
That goes without saying that success potential is distinctly higher.
3) Better Diversification Options
contrarian investing can also offer better diversification options.
You can look at investing in stocks, but also real estate, bonds and few other asset options.
This means you can also opt for greater income opportunity.
This also means your investment is better insulated from market movement.
As a result, for every penny that you invest in the markets, your return prospects are much better.
Additionally, you are buying stocks at comparatively lower levels.
That means you have more resources to invest in.
You can also increase the number of assets you can invest in.
This makes it a way more profitable strategy to invest in.
4) Hedging Risks
This goes without saying that contrarian investing helps you hedge risks.
Your risk is well spread out across asset classes.
This means that all your money is not parked in one place.
So, you can spread out your resources in a far more constructive manner.
Also depending on how an asset performs, you can increase or decrease your exposure.
So, whether the markets are bearish or bullish, your risks are significantly less.
In fact, it reduces the extent of losses.
So irrespective of your net exposure, the technique yields profitable results.
Disadvantages of Contrarian Investing
However, contrarian investing has some disadvantages as well.
One of the most important factors is the economic situation in which you are taking this call.
You must remember that your call is almost always dependent on the overall economic situation.
It will be the primary factor that will determine the extent of the fall or rise in the market.
Remember, you are going against the crowd.
Therefore, if your call is inaccurate, the chances of loss are also magnified to a large extent.
1) Economic Implications
Let me explain this as an example.
Around the middle of 2007, a lot of market players thought the market had fallen enough.
They ruled out the prospect of further loss.
Pessimism in the market continued till the end of 2007.
So, typically the principles of contrarian investing would indicate a rise.
But, the market decline continued unabated.
The situation only worsened with the passage of time.
Finally, in January 2008, the financial crisis hit global markets.
The extent of loss was significantly higher than anything they have seen ever.
Even at that phase, when there was deep despair in the market, it was not the best time to buy.
The damage on the street continued for an extended period.
However, you must remember that this was a special situation.
This was triggered by the sub-prime crisis and overall economic slowdown.
Contrarian trades perhaps are a better strategy when you deal with the usual ups and downs.
Economic problems by their nature have a very different character.
The extent of the damage is pretty widespread.
As a result, the pace of recovery is also much slower.
Therefore, in extreme market situation, this might not be such a great strategy.
It can only exacerbate the losses further.
Therefore, you need to study the realities a lot better before committing cash.
2) Market Psychology: An Important Factor
This is exactly why market psychology remains very important.
While your investment is not completely dependent, it is affected.
If you are keen on a contrarian strategy, pay attention to the prevalent market sentiments.
That will help determine the future trends considerably.
But don’t try to analyze the psychology in isolation.
The 2008 crash is the best example of this fact.
You have to analyze this psychology in tandem with the fundamentals I the market.
That alone can help you arrive at holistic solutions for trade.
This will also help you predict the market with better accuracy.
Moreover, market psychology along with a fundamental analysis will help you remain grounded.
It will help you identify cyclical euphoria in a more pronounced manner.
This means you can also use the market to your advantage a lot more effectively.
A Degree of Contrarian Investing Is Important
Though there are some flaws in the strategy, this is a fairly reliable one.
However, you need to identify the loopholes better for greater rewards.
Remember mass psychology alone or stock valuation in isolation cannot help.
It is essential to take a comprehensive and well-rounded view of the market.
This is why a contrarian call has to be well backed with the fundamental analysis.
An astute investor will also match the technical trends in the market to enhance profit.
Therefore, if you want a foolproof trading strategy, go for a comprehensive market analysis.
Look at the fundamental factors along with the economic implications of your contrarian investing.