Contrarian Investing uses an investing methodology that is based on the principle of ‘rationality’. To be a rational investor, there is a need to be realistic about both the upside and downside to any investment. An investor must first recognize the tendency to be both over-optimistic and over-confident in his or her investment decisions. An investor must also recognize the tendency to over-rely on so called ‘experts’ for investment decision making.
Contrarian Investing is a Rational Approach to Investing
The Contrarian methodology is rational because it attempts to determine if an individual company, industry or even an entire market is over-priced (irrational exuberance) or under-priced. A contrarian remembers that there were large periods of time in history in which investors received little or no return for being invested in the stock market.
The methodology is ‘contrarian’ because it disagrees with the efficient market hypothesis. The efficient market hypothesis states that stock prices reflect everything known about a company, an industry or an economy. Efficient market hypothesis states that stock prices cannot be predicted and that nobody can beat the market over time. Conversely, Contrarians believe that the market can be beat, by simply keeping a rational investing viewpoint: Contrarians control internal optimistic and pessimistic feelings and are independent thinkers.
Technical Analysis and Charting?
The investing methodology is ‘contrarian’ because it disagrees with technical analysis and charting techniques. If the efficient market hypotheses were to be true, technical analysis and charting would not be useful in predicting stock price movements because the current price would always be based on the current situation of the company. If the efficient market hypothesis were to be false, technical investors would believe that by studying charts and indicators, they could accurately project past performance into the future. Not too smart. A contrarian believes that forecasting cannot accurately been done.
The Contrarian’s methodology is based on one simple principle: people over-react. This tendency to over-react can be seen daily –at work, at home or even on vacation. People are highly emotional creatures –- especially when it comes to love and love for money.
The same holds true for investors: investors over-react. Investors over-react to both good and bad news. There is an internal psychological pendulum in people that moves between optimism and pessimism.
Investors overprice the “best investments” as can be seen in the latest technology bubble, and under price the “worst investments”. This will be shown in our examples later.
- Investors are simply too optimistic about stocks that appear to have good prospects.
- Investors are simply too pessimistic about those that have so-so outlooks.
Contrarian Strategy Execution:
A Contrarian Investor, generally focuses on turnaround situations and stocks currently out of favor, practicing patience and long-term investing.
One of the most difficult aspects of a contrarian strategy is the strategy’s execution. As investors, we face uncertainty when we invest our capital. It represents our savings and our financial security. An investor suffers the ultimate consequence of an erosion of capital when a bad decision is made.
The success of a contrarian investing strategy requires the investor to go against gut reactions, and against the prevailing beliefs in the general market. Going against the crowd, is not easy to do. This is why most investors don’t do it. But this is also why most investors and financial managers do not beat the performance of the market index. Most of us are influenced by societal pressures (co-workers, friends, family) that encourage the social norm. Deviant thinking from the norm is difficult because of the lack of positive reinforcement for doing so.
The reality is that a contrarian strategy takes time, discipline and patience — and most investors will give up on contrarian investing in the short run because there is optimism somewhere else in the market. Most people are drawn towards exciting new concepts and ideas with a hope for an investment home run. This home run approach is just not realistic as can be seen in the latest technology bubble and burst.
Still, most investors who try contrarian investing will simply not be able to stick it out for the longer term, because of these optimistic and pessimistic psychological influences.
Contrarian Investing Philosophy
Contrarian investors look for strongly financed, growing companies that are undervalued by the market for the wrong reasons, believing that the market will come to appreciate their true value over time. This investing approach can also be described as Contrarian, since such stocks are purchased when most investors believe that they are unattractive.
It is also believed that by owning an undervalued quality stock, is a lower-risk method for seeking superior long-term returns. These stocks tend to be less susceptible to price declines in bear markets because expectations about their performance are already low.
In addition, these stocks may offer the benefit of a relatively high dividend yield, which provides the best protection against the downside of an investment.
No longer will you be looking at stock investments through the basic “Good/Bad” prism that so many waste their time doing; you’ll instead be looking at stocks through smart and intellectual investment decisions built upon sound logic and contrarian principles.
Indeed, this is the logic-first, ego-later approach that the likes of David Dreman, George Muzea and Warren Buffett are benefiting from every day. It’s no longer a place for cut and paste strategies, instead being replaced by a marketplace which experiences massive changes in trends, growth and performance like few others before it.
Nothing hurts an investor more than simply learning about what to follow in any given moment – you’ll learn nothing about how to take initiative for yourself and make smart investment decisions based on your own learning.
Believe it or not, Contrarians are not alone in their investment beliefs, although at times it feels like it.
It is not easy to be a Contrarian minded investor, in today’s fast-paced and get-rich-quick ideological investment environment.
Contrarians live by the following rules:
- Contrarians concentrate on turnaround situations, and stocks currently unpopular but likely to regain popularity in the medium to long term future.
- Contrarians focus on stocks that have the ability to appreciate in value – by using the Contrarian strategies.
- Contrarians analyze management’s ability to achieve stated goals and take the appropriate action.
- Contrarians invest only in organizations that have existed for at least ten years.
- Contrarians stay up-to-date on current events; focus on key, out-of-favour industries; and shop for bargains which allow for optimal returns.
- Contrarians normally sell 50% of a stock upon achievement of our rational target price, while “market timing” the remainder.
- Contrarians practice patient, longterm investing, while ignoring the daily fluctuations of the market.
- Contrarians advocate strict diversification in our portfolio.
- Contrarians remain independent and skeptical of every broker, corporation or financial institution.