Following the herd is a sound strategy for sheep, and actually works quite well for most investors. Buying investments that the consensus supports can often provide steady performance and minimise nasty surprises.
Contrarian investing takes a very different approach. It is an investment style which goes against prevailing market trends, selling when others buy and buying when mainstream investors are selling.
There is more to this than simply being different for the sake of it. Contrarian investors believe that when most people say the market is going up they will have already invested and that it has therefore peaked. Conversely, when other investors predict a downturn, they have already sold out. The shares they have sold out become bargains when the market goes up. It can mean spectacular profits. But of course, it can mean spectacular losses as well.
It is not an investment strategy for the faint hearted. But can it really work?
When contrarianism pays
Contrarian investors can make profits if they target distressed stocks and then sell them once the share price has recovered and other investors begin targeting the company as well. They can also avoid losses if they get out of a particular holding as the market peaks.
However, if the market is right and the contrarian is wrong, it means missing out on profits, and possibly making some major losses.
There is actually a fine line between the contrarianism and value investing. Both value and contrarian investors look for stocks whose share price is lower than the intrinsic value of the company. Both strategies look for undervalued securities based on their reading of the current market sentiment, but contrarians may focus on the stock price movement. However, simply buying falling stock in the optimistic belief it will shortly be heading up again is a recipe for disaster. It may be falling for a very good reason, and the company that issued it may be set to fail completely. To be successful, contrarian investors have to know exactly what is going on, and this requires in-depth knowledge.
Could it work for you?
Contrarian investing is hard enough for professionals, let alone private investors. It means having a finger on the pulse of the market, and an up to the minute knowledge of what other traders are saying (and more important, doing).
During times of extreme market volatility, the safe option may be to protect your portfolio. When most investors are looking to ‘safe haven’ assets such as cash and bonds, the contrarian will be looking for opportunities. The fact that most people will see these opportunities as threats is the core of what contrarianism is about.
It helps to have an understanding of why any particular stock is out of favour. Market sentiment is fickle, but a fundamental problem could mean a particular stock really is as toxic as everyone thinks.
You then need absolute faith in your own judgement to go against these market trends. Contrarian investors may need to take a very long-term view when it comes to picking and choosing stocks.
In a nutshell – contrarian investment can generate large gains, if you are one of the Warren Buffets of this world. For the rest of us who are neither very wealthy or full-time expert investors, an investment portfolio that is designed around your own appetite and capacity for risk may be a wiser solution. If it includes any contrarian elements at all, they should probably only represent a very small part of our broader holdings.
The value of investments can fall as well as rise and you may get back less than you invested.
forbes.com – 5 Rules Of Contrarian Investing – April 28th 2014
investopedia – Herd Instinct