Defining a Contrarian
Buying when most investors are selling and selling when others are buying are two deliberate strategies used by contrarian investors to go against the current market trends. Warren Buffett, the CEO and chair of Berkshire Hathaway, is a well-known contrarian investor to name.
Investors who are contrarians think that those who predict an increase in the market only do so when they are completely invested and have no more purchasing power. The market is at its pinnacle right now. As a result, by the time someone predicts a fall, the market has already reached its peak and can only rise further.
The Contrarian Strategy
As the name suggests, contrarian investing is a method that entails defying the current state of investor sentiment. One can apply the ideas of contrarian investing to certain derivatives, an industry, or even whole markets.
When others are pessimistic about the market, a contrarian investor enters it. The contrarian thinks there is an opportunity because the market or stock is worth less than it should be. Essentially, a lot of other investors’ pessimism has driven the stock price below its fair value, and the contrarian investor will purchase that stock before the general mood shifts back and the share price rises.
Contrarian investor and author of Contrarian Investment Strategies: The Next Generation David Dreman claims that investors undervalue the profits of troubled firms, overreact to news events, and overprice “hot” stocks. This overreaction gives opportunities for the contrarian investor to select inexpensive companies by limiting upward price movement and causing precipitous losses for “hot” firms.
Value Investing vs Contrarian Investing
Since both value and contrarian investors seek firms whose share price is less than the company’s fundamental worth, contrarian investing and value investing are related. Value investors typically think that the market overreacts to both positive and negative news, which leads them to conclude that short-term stock price fluctuations don’t reflect a company’s long-term fundamentals.
Value and contrarian investing are similar in that they both seek cheap stocks to benefit from by interpreting the mood of the market, but many value investors believe that there is a subtle distinction between the two.
Examples of Contrarian Trading
Warren Buffett is the most well-known illustration of a contrarian investor. One of his most well-known sayings, “Be fearful when others are greedy, and greedy when others are fearful,” encapsulates his contrarian investment philosophy.
During the peak of the 2008 financial crisis, Buffett advised investors to purchase American equities as the markets plummeted amid a surge of bankruptcies. He bought stocks in American corporations, such as investment bank Goldman Sachs Group, Inc. (GS), as an illustration.
After a decade, his counsel turned out to be accurate. The shares of Goldman Sachs had increased by almost 239% from 2008 and 2018.
Drawbacks of Contrarian Trading
A contrarian investment technique has significant disadvantages that investors should be aware of before using it. Finding cheap stocks may be difficult, and contrarians usually devote a lot of time investigating different industries and firms in order to identify good investing possibilities. Merely acting in opposition to the emotion of the market will not be sufficient. To effectively determine a security’s inherent worth, contrarians need to hone their fundamental analysis abilities.
There may be times when contrarians’ investments underperform. It might take a long time for a cheap stock to start making money. The contrarian investor might have to bear paper losses on their assets in the interim.
The Bottom Line
A contrarian investment approach is one that seeks profitable trades that deviate from the mood of the market. For instance, the contrarian investor will be bearish and seek opportunities to sell if the market is bullish. On the other hand, the contrarian is bullish and will search for opportunities to purchase if the market is bearish.
It is wise to always practice mindful trading before embarking on any financial journey, regardless of the techniques used since none are fail-proof.
