There are many investment strategies most people employ when they first enter the market. From angel investing to value investing, many of these strategies are popularised by household names of present-day billionaires. One such strategy is contrarian investing.
What is contrarian investing?
An investment style in which investors purposefully avoid market trends by selling when others buy, and vice versa, is known as contrarian investing. Contrarian investors share the belief that people who argue that the market is going upward do so only when they have no more purchasing power and are fully invested. During this time, the market is at its peak. Hence when the market turns downward, those who cried that it’s going up have already sold out their shares, and the market can only go up at this point.
Hence, as the name implies, contrarian investment strategies deliberately go against the grain of the prevailing investor sentiment in the market. Contrarian investing principles can be applied to individual stocks, entire markets, or niche industries. Most times, contrarian trading involves investors entering the market when others have a negative sentiment towards it. Contrarians go with the assumption that the value of a stock or market is currently below its intrinsic value. Hence, investing right now makes for a great opportunity.
According to the contrarian mindset, high amounts of pessimism have pushed the stock price below the amount it should be. The contrarian investor will go ahead and buy the stock before the broader market sentiment returns, and the price of the share rebounds. The contrarian logic is seen when investors overprice the ‘hot’ stocks and undervalue those which are distressed. The overreaction causes a limited upward price movement. Alternatively, there are steep falls for the stocks that are considered ‘hot.’ This makes space for the contrarian investor to pick underpriced stocks.
How Contrarian Trading Works:
Firstly, contrarian investors enter the market when the sentiment may be overwhelmingly negative. They pick distressed stocks and aim to resell them once the share price is recovered. Around this time, other investors have begun targeting the company as well. The fundamental idea with which a contrarian investor operates is that herd instincts can take control of the direction of the market’s flow but doesn’t necessarily make for a great investing strategy.
However, in cases where the broadly bullish sentiment of the market proves to be true, working as a contrarian can also lead to missing out on gains. One can end up selling their holdings once the market ends up gaining against their better judgment. On the other hand, a stock that is undervalued and targeted by contrarians as an opportunity to invest can continue to remain undervalued in case the market sentiment remains bearish.
Value investing vs contrarian trading strategy
Contrarian investing is quite similar to value investing. Both share the similarity of picking stocks that are currently undervalued by the prevailing market sentiment. The assumption is that the inherent value will eventually reflect through the stock’s share price. Similar to contrarian investing, value investors also believe that the market tends to overreact to both good and bad news. It follows that short-term movements in stock prices do not correspond with the long-term fundamentals of the company.
As a point of distinction, according to many value investors, there is just a fine line between contrarians and value investors. In fact, most popular value investors are commonly referred to as contrarians in their approach due to seeking out stocks that are distressed and appear to be undervalued against their inherent worth. One such example is Warren Buffet. At the peak of the 2008 financial crisis, Warren counseled that investors buy American stocks which seems like the last thing the market wanted to do. This advice proved to steadily make a difference and ten years later revived the economy to a functional level.
The contrarian strategy involves investing in stocks that appear to underperform while the market sentiment towards them remains negative. This sentiment makes for a great entry point for contrarians also, as they enter at a point in which the market may change its direction. Warren Buffet — the value investor — is often compared to contrarian investors because of his quote to be fearful when investors are greedy and greedy when they are fearful — a classic contrarian philosophy.