What is contrarian investing? What you should know

Contrarians challenge the status quo: if everyone else is moving in one direction, they deliberately move in the opposite. Contrarian investing involves placing your money into assets that go against prevailing market sentiment. When the majority of investors are selling, contrarians see potential and buy; conversely, when there's a rush to buy, they often sell.

Understanding contrarian investing

Financial markets are often driven by herd mentality, where most participants share a common outlook—whether it's optimism that the market will continue to rise or pessimism that it will soon decline. Contrarian investing, however, is all about adopting a perspective that defies the prevailing consensus and then meticulously researching to uncover potential investment opportunities that others might overlook.

For instance, if the general market sentiment is that economic growth is set to accelerate, leading to further market gains, a contrarian might take the opposite view. They might believe that the economy won't pick up as expected and that stock prices are likely to fall as a result. This contrarian stance can lead them to make investment decisions that reflect this opposing viewpoint.

The essence of contrarian investing was famously captured by Warren Buffett, who advised, "Be fearful when others are greedy, and greedy when others are fearful." This mindset requires not only a thorough understanding of market conditions but also the patience and discipline to act on an unpopular view.

Developing a contrarian strategy often requires weeks or even months of analysis. Moreover, it can take considerable time for the market to validate a contrarian perspective. During this period, contrarians must be comfortable with the potential risks and losses that may arise while waiting for the broader market sentiment to shift in their favor. By positioning themselves ahead of these shifts, contrarians aim to capitalize on opportunities before the majority catches on.

How does contrarian investing work?

Contrarian investing begins with a deep understanding of the consensus view on a particular stock, sector, or the broader market. The idea is to analyze the prevailing opinion thoroughly, whether it’s overwhelmingly positive or negative. From there, a contrarian investor challenges the consensus, identifying flaws and developing a well-reasoned argument that supports a contrasting viewpoint.

For instance, if most investors are optimistic about the stock market due to expected economic growth—referred to as a "bull case"—a contrarian might take the opposite stance by constructing a "bear case." They might argue that the anticipated economic growth won't materialize as expected, leading to a market downturn or underperformance in certain sectors.

Contrarian investors might also take a bullish position when the market sentiment is predominantly bearish, especially with individual stocks or sectors that have fallen out of favor. This approach is common among hedge funds, which often adopt aggressive contrarian strategies in search of undervalued opportunities.

Contrarian investors typically have a long-term perspective. Their goal is not to chase quick profits but to uncover opportunities where the market’s consensus view is likely wrong. They invest with the expectation that, over time, the market will correct itself, and their contrarian view will be validated, leading to significant returns.

However, this approach comes with challenges. Contrarian investors must be prepared to endure short-term losses and the uncertainty that comes with holding an unpopular position. The patience and conviction to stick with their strategy, even when it goes against the grain, are crucial for eventual success.

Pros of contrarian investing

Contrarian investing is attractive for several key reasons. First, when successful, it allows investors to identify opportunities where the market's herd mentality is mistaken. This can lead to outperforming the broader market and other investors. By defying the consensus, contrarian investors may uncover undervalued assets that others overlook, positioning themselves for significant gains once the market corrects its course.

One popular contrarian strategy is to buy stocks during a bear market or when stock prices are falling. Even if they don’t pinpoint the exact market bottom, contrarians who buy when others are selling can see substantial returns as stock prices recover. This approach requires patience and a long-term perspective, but the rewards can be substantial.

Beyond financial gains, there is also a sense of personal satisfaction that comes with successful contrarian investing. This strategy demands extensive research, market expertise, and a willingness to go against popular opinion. When a contrarian view is eventually proven correct, the investor enjoys not only monetary rewards but also the intellectual gratification of having outsmarted the market.

Cons of contrarian investing

However, contrarian investing comes with its own set of challenges. Developing a contrarian viewpoint requires a high degree of curiosity, independent thinking, and the time needed to thoroughly research individual stocks, market sectors, or the overall market. This process can be time-consuming and mentally demanding.

Maintaining an out-of-consensus viewpoint requires significant fortitude, especially when it means waiting for months or even years for a strategy to pay off. Contrarian investors need to have the financial resources and patience to endure potential short-term underperformance, which can be discouraging when the market continues to move against their position.

There is also an opportunity cost involved in contrarian investing. Money tied up in a contrarian strategy that takes a long time to bear fruit could have been invested elsewhere, possibly yielding better short-term returns. Investors must be comfortable with this trade-off and the inherent risk that comes with it.

Lastly, contrarian investing is not as accessible to most investors as other strategies. The extensive research and expertise required to develop sound contrarian theories make it a more complex and demanding approach. While the prospect of proving other investors wrong is appealing, the difficulty of correctly timing market moves adds an additional layer of risk that not all investors are prepared to handle.

Contrarian investing vs. other investing strategies

Contrarian investing is a form of active investing, as it involves actively seeking to outperform the market by going against the prevailing market sentiment. Unlike passive investing, which aims to match the market's performance through strategies like index investing, contrarian investors take a proactive approach in identifying opportunities where they believe the market is wrong. This makes contrarian investing more hands-on and research-intensive compared to passive strategies.

Contrarian investing is also more aligned with long-term investing than with day trading. While day traders focus on short-term price movements and aim to profit from quick, often intraday, trades, contrarian investors typically adopt a longer timeline. They may hold their positions for weeks, months, or even years, waiting for the market to eventually recognize the value they identified early on.

Contrarian investing shares similarities with value investing, as both strategies seek to identify undervalued assets that have been overlooked or mispriced by the broader market. Both contrarian and value investors are on the lookout for stocks that are trading below their intrinsic value, with the expectation that the market will eventually correct itself and bring prices in line with true value. However, while value investing is generally focused on fundamentals and financial metrics, contrarian investing also incorporates an analysis of market sentiment and psychology, looking for situations where the consensus view may be flawed.

Contrarian investors may also find common ground with short sellers, who profit from declining stock prices by "shorting" a stock. Both contrarians and short sellers challenge the prevailing market opinion, but they differ in their approaches and timelines. While short sellers typically operate on a shorter timeline, aiming to profit quickly from a drop in a stock's price, contrarian investors often take a longer-term view. They are just as interested in opportunities where asset prices might rise as they are in those where prices might fall.

In summary, contrarian investing is distinct in its focus on challenging market consensus and its long-term approach, but it can overlap with other strategies like value investing and, to some extent, short selling. This approach requires patience, research, and a willingness to hold unpopular views in pursuit of potentially significant rewards.

Famous contrarian investors

Warren Buffett, renowned for his value investing, also embodies many principles of contrarian investing. Buffett has amassed significant wealth by identifying and capitalizing on overlooked opportunities in the stock market. His investment choices are closely followed and analyzed, given their potential to yield substantial returns. However, Buffett has cautioned against rigidly adhering to any one investment strategy, stating, "Don’t get caught up with what other people are doing. Being a contrarian isn’t the key, but being a crowd follower isn’t either." This emphasizes his balanced approach, where independent thinking and thorough analysis are key, rather than merely going against the grain for its own sake.

Another prominent figure in contrarian investing is Michael Burry, a hedge fund manager featured in Michael Lewis' book, The Big Short. Burry famously predicted the subprime mortgage crisis, making significant profits by betting against the housing market when most were confident it would continue to rise. His success as a contrarian investor highlights the potential for substantial gains when one correctly identifies flaws in the consensus view.

Several other professional investors are known for their contrarian strategies, including:

• Bill ackman: A hedge fund manager known for his bold contrarian bets, such as his successful short position against the bond insurer MBIA during the financial crisis.
• George soros: Famous for his contrarian bet against the British pound in 1992, which earned him over $1 billion in profits and the nickname "The Man Who Broke the Bank of England."
• Ray dalio: The founder of Bridgewater Associates, Dalio is known for his unconventional and contrarian views on the economy and markets, which have often led to successful investment outcomes.
• Marc faber: An investor and commentator who is well-known for his contrarian outlooks on global markets, often predicting economic downturns and market corrections when others are bullish.

Recent events also underscore the impact of contrarian viewpoints. In early 2021, a group of retail investors on social media platforms like Reddit identified stocks that had been largely abandoned by institutional investors, such as GameStop and AMC Entertainment. These so-called "meme stocks" experienced explosive gains as amateur traders piled in, driven by a contrarian theory that these stocks were undervalued or overshorted. While some investors profited handsomely from this contrarian approach, the fundamentals of these companies couldn't sustain the inflated prices, and their stock values eventually declined.

These examples demonstrate that contrarian investing can yield significant rewards, but it also requires a deep understanding of market dynamics, a willingness to go against popular opinion, and the fortitude to withstand potential losses before a contrarian thesis is validated.