Contrarian Investing: Avoid the herd mentality!

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Investing is often perceived a hazardous pursuit. However, it need not be so hard if one applies common sense, hard work, consistency and patience. In fact, there is good chance, you may even manage to get it right!

Being a Contrarian

Contrarian investing is all about thinking on your own terms, it is more behavioral in a sense. A contrarian believes that certain crowd behavior (e.g., panic selling) among investors can lead to mispricing in markets and create opportunities for profit. By acting contrary to the consensus, contrarians stand to profit when the sentiment turns. This however, does not mean that one has to think and act contrary at all times.
 
Picking up the stock or sector which is not the most coveted is primarily what the contrarian style is about. One is scouting for stocks that are grossly under-priced and has potential which remains unlocked. There have been numerous Contrarian Investors, who have been very successful at this game. One of the most popular and successful contrarian investors being Warren Buffet, who believed in, �Buying a spectacular stock for a reasonable price and not in buying a reasonable stock for a spectacular price�.

The Pros

Contrarian investing can be extremely rewarding if applied prudently, it is about identifying patterns of greed and fear which can be diligently used to one�s best advantage to optimize returns. A look at how the equity markets have panned out over the past could give valuable cues on how one could have used the market movement to time the entry and exit to the best of ones ability and with good intentions for the portfolio �

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

There are instances where one could have gauged the sentiment from the intense buy/sell activity. In the above figure, in Oct �09 and Oct �10, the markets were creating new highs and clearly the RSI (relative strength index) had moved to the overbought zone which suggested that the P/E expansion was severe and over the medium term, a correction could be expected. As expected, in a few months, one saw markets enter the oversold zone. If we were to look at the current trend, the market is in the oversold zone, one is not sure how long it would last in this space, but sooner or later it should turnaround and one could see the markets coming back to relevant valuations. This could be the right time to get your shopping bags out, but you need to tread carefully, for you do not know how long it is likely to linger here or how deep it could cut. Investing in a falling market is like trying to hold a falling knife, you are bound to get hurt severely if you get the timing wrong. One could however, never predict the market�s bottom, hence it is best to use the cost averaging technique, especially in the falling market.

The Payoff

After every fall, the market has risen and delivered phenomenal returns. A contrarian understands this very cycle and exploits it to the maximum extent. Many of us have witnessed the 2008 debacle and know that what went down sharply, has bounced back in good health over a period of time.

 

 

 

 

 

 

 

 

Source: Right Horizons, BSE India; *As of 10 August, 2011

The downside

Everything in the world has 2 sides and so does contrarian investing. If not implemented prudently, it could turnout to be a disaster. The disadvantage of contrarian investing is its high volatility. Contrarians must be able to get into a falling market and be prepared to see their investment plunge lower. Similarly, they must also be able to get out of the market while it reaches new highs. Investing merely against the consensus, without careful fundamental analysis could potentialy result in some contrarians investing during a panic sell down months before a company declares bankruptcy or get�s delisted. �Contrarian� in such circumstances could prove to be a case of awful judgement.

Contrarian investing is not all about emotions; it is a long-term strategy and is potentially very profitable. It is about overcoming one�s emotions and playing on the emotions (fear or greed) of the �crowd�. Even as you take a �contrarian �position�, it is important to have the rationale in place.