Human beings are vulnerable to fads and crowd actions. There is a strong human tendency to assume the consensus view is correct and to mimic the action of a larger group. However, an investment looks like a sure thing to everyone may eventually turn out to be a disastrous investment decision. That’s why many history’s world-class contrarian investors say we should always be ready to stand out from the crowd.
“When everybody thinks alike, everybody is likely to be wrong”. -The Art of Contrary Thinking (1954) by Humphrey B. Neill
What is Contrarian Investing?
Contrarian investing is, as the name implies, a strategy that is characterized by purchasing and selling against the prevailing investor sentiment at a given time. It is often considered as a long-term opportunity investing and a contrarian believes that certain crowd behaviour among investors can lead to exploitable mis-pricings in asset prices, i.e., there is a big discrepancy between the intrinsic value and the current market price of the asset and thus represent an opportunity for a windfall profit. For example, widespread pessimism about a stock can drives its price too low that it overstates the related risks, but understates the prospects for long-term profitability. Therefore, identifying and buying such distressed stocks, and selling them after the company recovers can lead to above-average return to the contrarian investors. Likewise, widespread optimism can lead to excessive valuations that may eventually reverts, as those extremely high expectations don’t pan out. The principle behind contrarian investing can be applied to individual stocks, a sector as a whole, the entire markets or even any other asset class.
According to JP Morgan, the average investors vastly underperform to every investment class (figure 1) as many of them tends to follow the trends by taking money out of the funds/stocks that have recently underperformed and then put it into those that have performed well. However, these “crowd following” actions in fact are following success that has already occurred but fails to identify the success that will likely happen in the future. As a result, crowd investors are easily “buying at peak, selling at bottom”, and this supports contrarian’s view that following the crowd is always not a good investment strategy over the long term.
Figure 1. Average investors vastly underperform to every investment class
Source: JP Morgan, Noble Apex/iFund
Is contrarian investing sounds like value investing?
Yes, the two are very similar in nature as both type of investors are based on careful analysis and understanding of the inherent worth of businesses to find out mis-pricing opportunities. They generally believe that market overreacts to good and bad news, so the asset price movement in the short term don’t correspond to long-term fundamentals. On the other hand, in addition to looking at financial metrics such as the book value or P/E ratio as value investors do, contrarian investors are also interested in measures of “market sentiment” among other investors, such as sell-side analyst coverage, consensus forecast, trading volume as well as media commentary. Besides, some contrarians may invest into more exotic financial instruments such as credit default swaps or contrarian option-selling to play in overarching trend, while value investors tend to invest in single securities only.
All in all, contrarian investing could be an extremely rewarding strategy when you get it right, in particular during periods of bubbles and extreme market over-reaction. However, adopting a contrarian approach requires very rigorous analysis of the idea. The contrarian needs to find out the intrinsic value of the assets, sees what most people are doing, understands what’s wrong about the market and withstands the psychological pressures like social proofing as the predicted outcome may take a much longer period to fructify. Last but not least, investor should not apply a contrarian approach blindly just for the sake of not following the crowd as it can be an equally foolish thing to do.
“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right” -Warren Buffett