How effective is contrarian investing strategy?

Contrarian investing is when an investor goes against the investing crowd - selling what other investors buy and buying what the others sell. Contrarian investors, like David Dreman, believe that investors tend to overvalue certain asset classes and underestimate others. Such overreaction backfires when the much-anticipated asset does not perform overly well, leading to its crash, leaving contrarian investors to buy it up.

In this article, we will look at contrarian investing and answer the following questions: 

• What is contrarian investing?
• How effective is contrarian investing?
• What contrarian investing tactics you can use to your advantage?

1. What is contrarian investing?

Contrarian investing is a strategy where investors go against the mainstream investment behaviour to make a profit. If the crowd is focusing on tech stocks, contrarians will do the opposite and sell them and only buy them when the hype dies down with the price. Contrarian investors believe that others only overvalue their assets because they have put all their eggs into that basket. They have no other option or purchasing power; therefore, their investment has to increase. To a contrarian investor, once the asset hits its peak - downward is its only natural course, and once an asset has met its low point, upward is the only direction. Hence, they will only prefer to buy an asset class once the value decreases and wait until it peaks again. In fact, contrarian investing only focuses on buying distressed assets and sell them once it gets popular amongst other investors.  

A contrarian strategy can be beneficial, especially if the investor does not give in to the market fear and excitement propagated by the media outlets. Since they are aware that you cannot time the market, they take control over their own investments through the contrarian approach.

Contrarian investing and value investing have some similarities - they both tend to lean towards undervalued assets they believe have an intrinsic value. Value investors also believe that the market tends to overreact to everything, and therefore, they jump on the short-term profit bandwagon.

2. How effective is contrarian investing?

Contrarian investing can be very effective in bringing better yields because it goes against the norm. Since the average investors tend to focus on short-term goals and buy high and sell low, their portfolios underperform in the market. 

A contrarian investor does the opposite - buying low and selling high and investing in assets when others are selling them. They constantly try to identify the assets which will bounce back from their downfall and reach new heights. Unlike the average investor, a contrarian investor will understand the nuances of market profit and loss. 

A well-known contrarian investor is Warren Buffet, who has bought undervalued assets that grew significantly in the future. He repeated the same tactic during the 2008 crisis when he bought off some of the financial companies facing bankruptcy. 

Does this mean you have to take high risks for higher rewards? Not at all; risks depend on your tolerance. While all investments carry some form of risk, not all contrarian investing has high risk. Some can hedge against the risk by shorting their investment. It all depends on the risk tolerance of each investor. 

However, like everything, contrarian investment has its downsides too. Even contrarian investment carries a low probability of success for the following reasons:

• Shorting investments may be time-consuming because it takes a long time for the value of investments to increase than decrease and an increase in one equity leads to elevate all others. Therefore, making a profit on shorting is next to impossible
• Contrarian investment still requires timing the market, which is tough, even for the most experienced investor
• Just because you find an intrinsic value in the undervalued asset does not mean it will yield profit. Some drops remain for a long time and may even go down further, incurring losses for contrarian investors (e.g. US Natural Gas stocks)
• Contrarian investing requires investors to identify the stocks and assets which are likely to implode in the future. That means a set of knowledge and expertise is absolutely mandatory to pick the best out of so many. If a group of experts and professionals cannot do that without suffering losses, how can an individual, with limited training and knowledge, expect to capitalise on it?

3. What contrarian investing tactics you can use to your advantage?

Sometimes the market is right - especially when so many people agree with it. Of course, you may be right if you have knowledge that no other possesses, but even then, the odds are stacked against you because you put your money in a dying product, and if it fails, you lose your money. Therefore, there are some contrarian investment tactics you can use to, at least, minimise your losses:

• Developing industry: New markets are developed every time. Examples are mostly related to tech, but it is not limited to it. While some traditional markets will remain, new markets will emerge and will take over the economy
• Commodities: Commodities include grains, gold, oil, gas, and many more, and these are the assets that are necessary for the economy and will rarely see a decline in value
• Non-traditional investments: This is not an alternative investment. These investments trade on things that are unusual and very different from the investment market in general - it could be ETFs on cannabis, pot stocks, funds on beer or wine or even NFTs
• Transportation: Cruise lines and airlines were hit hard in 2020, but they are more likely to bounce back due to their importance in the economy
• Small mom&pop business: Many small businesses have also been hit by the pandemic, and many of them will not bounce back. But some might through implementing innovative measures to suit the market climate, and an investor can take reap the benefits from their slow regrowth
• Real estate: Real estate is one of those asset classes that rarely crashes. Even when it does, it comes back up stronger than before. Real estate, whether land or through REITs, can still achieve a solid return that suits a contrarian approach. Also, not everyone can afford to invest in real-estate

Additionally, you can implement the following steps to achieve contrarian strategy in your investments:

• Leaving it to the professionals - shorting is the key strategy of contrarian investment, and it can be very rewarding or suffer huge losses. As an individual with no training or knowledge, it is better to seek a professional who has the training required to help you with your investment
• Pick durable companies - companies that have been hit hard and managed to come back have implemented measures to survive throughout the pandemic. Choose the companies to invest in which constantly strives to innovate and adapt to the current market climate
• Research - nothing beats good old-fashioned research before investing in anything. Now that everything is available online accessing studies on investment is easier than ever. Utilise those access and make them work in your favour
• Diversify - the golden rule of investment, and it applies here like anywhere else

Contrarian investing can be beneficial if done right. However, as seen from history, only a few can reap the benefits because it requires expert support from trained professions. Warren Buffet had a group of professionals who helped him profit through a contrarian approach, and the individual will not have access to such tools. Therefore, it is essential to understand your goals, risk tolerance, and the current market before investing through the contrarian approach. 

Last update: 06/08/2021