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Warren Buffett once said that it’s a good idea to “be greedy when others are fearful, and fearful when others are greedy.”
In many ways, this describes the strategy contrarian investors adopt.
Contrarians look to find “hidden” opportunities by going against the grain and general market sentiment. This can be difficult – it’s tough to keep your convictions if everyone else is doing something different to you.
Many famous investors – think Buffett, Bill Ackman and George Soros – have deployed contrarian strategies at some stage of their careers. Let’s look at some of these in more detail…
What is contrarian investing?
The contrarian investor goes against the herd, often selling assets that are hugely popular and buying those that have been sold-off by the broader market.
Contrarians often feel that when the market is bullish, a crash could potentially happen. Why do they believe this? The thinking roughly goes that, because everyone who is likely to buy already owns the asset (or assets), there is no one left to keep the price up. And with no buyers at high prices, those who are selling are forced to sell at lower prices – therefore, dropping the price.
Of course, this scenario can play out in the opposite way. When an asset is seemingly universally disliked, that’s when contrarians feel it could rally. There’s no one left willing to sell the security at a (likely) knocked-down price.
Who are typical contrarians?
To a certain extent, anyone can be a contrarian. All it takes is the ability to successfully notice when a stock is being pushed way higher or sold off way more than you believe is justified. Experienced investors will often keep an eye out for indicators that one of these scenarios is happening.
However, investors who are perpetual contrarians, and make contrarian investing their primary strategy, often like to do things differently. They dislike the status quo, enjoy pushing their limits and are comfortable being uncomfortable.
Such investors are OK with being criticised for their views (or they don’t express them). After all, most people who are part of the majority will be on the other side of the trade they want to make. They are also not afraid to take continued small losses as a market grinds higher. They can tolerate this if they think there will eventually be a large and sharp decline that will give them an opportunity to make an overall profit.
Contrarians like good deals, which most often occur in the financial markets after a price decline, and they typically see big price rises as a chance to sell their holdings.
Why is contrarian investing difficult?
In terms of execution, a contrarian investment approach is no more difficult than any other strategy.
For investors who are natural contrarians in other areas of their life, this style of investing may come more easily than following more popular market trends. But someone who’s not a contrarian by nature may find following such a strategy a little uncomfortable.
Market sentiment doesn’t always turn quickly. That means it may take weeks, months or years for a contrarian’s convictions to come to fruition. Understanding your time horizon and risk tolerance is therefore essential if this is an investing strategy you want to pursue.
For contrarian investing strategies
Having established what contrarian investing is, let’s look at some of the ways in which its deployed…
Value strategy – Contrarian investing can overlap with value investing. When a stock’s price falls – meaning a lot of people are selling it – but the fundamentals of a company are still sound, that may present a buying opportunity.
Price to earnings ratio (P/E) is one valuation method used to assess this. The P/E ratio is calculated by dividing the earnings per share figure by the market price of the shares.
A contrarian may be interested in a stock if its P/E ratio is lower than usual. The thinking would be that the stock’s intrinsic value – i.e., what the investor really believes it’s worth – is significantly higher than where it’s currently trading.
This, of course, can work another way too. If a contrarian already owns a stock and sees its P/E ratio rise considerably, they may decide it’s now overvalued and sell the asset.
Market sentiment – Market sentiment refers to how bullish or bearish other investors’ opinions or positions are. When sentiment is extremely bearish – i.e., when investors are either selling a lot of assets or refusing to put money to work – a contrarian would look for buying opportunities. When sentiment is extremely bullish and investors are buying lots of stocks, a contrarian would be assessing which assets it’s worth selling. Sentiment can be used for short or long-term trades.
Market sentiment is gauged by a number of indicators. Some traders develop their own indicators, while others use publicly available ones, such as the CBOE Volatility Index.
Often, these indicators are based on behavioural finance, a field of study that looks at how emotions affect financial decisions. When they’re fearful, people sell, often without regard for logic or intrinsic value. Those who remain steady and logical can then potentially capitalise and scoop up some deals.
Mean reversion – This involves looking at the long-term average performance of stocks or the overall market and making investment decisions accordingly.
A contrarian, for example, may see stocks pullback to prices below their long-term average –and this could be a signal to buy. On the other hand, if stocks move significantly above their long-term average – a sign that plenty of people are buying them – a contrarian may decide to sell out of certain assets.
This approach can be used with price itself or with fundamental statistics such as P/E or book value.
Volatility analysis – Market selloffs are typically associated with high volatility and fast drops in the price of assets. Quite often, market rallies are marked by low volatility and small, steady price rises.
Contrarian investors expect these conditions to reverse. Periods of high volatility, they believe, will be followed by a time of low volatility – and vice-versa. They’ll monitor the markets and make investment decisions accordingly.
Is it for you?
As we noted earlier, if you’re planning on becoming a contrarian investor, it’s important to understand your risk tolerance and time horizon before doing so. Familiarising yourself with how to assess stocks and which metrics you need to pay attention to is also important.
While many of the world’s most-noted investors have deployed contrarian strategies at some stage, these don’t always have a positive result. Being a contrarian can be the wrong call – and plenty of people have been able to meet their investment goals by following the crowd.
Still, if you’re happy to swim against the tide, it’s an approach that can lead to some success.