Stock market investment: Want to be a ‘contrarian investor’?

By: | Updated: July 12, 2016 8:55 AM

A contrarian investor goes against the market and he will never ever follow the crowd and aims to identify stocks that one has considered

dealAs a contrarian investors, you should buy when everyone wants to sell and sell when everyone wants to buy. You have to be in fundamental disagreement with majority of the other investors in the market. Going against the crowd is not easy to do, that is the reason why majority of the investors are not able to beat the performance of the market returns.(Source: IE)

Contrarian style of investing is useful in stock picking, especially in volatile market conditions. It is based on the basic premise that the most recent market conditions are not realistic, and therefore, they make investment decisions that deviate from the general direction of the markets. In other words, a contrarian investor goes against the market and he will never ever follow the crowd and aims to identify stocks that one has considered.

This style is adapted and promoted by Warren Buffett. Let us discuss some of the major features of this style of investing.

Information asymmetry

There is always an information gap among multiple players in the stock market. When you read that a company got a big order or stock split, dividend announcement, etc. its effect is already over in the market. We are living in the world where market news moves fast and it impacts the price in micro seconds and the market has already repriced before the news get printed.

Enter when everyone exits

As a contrarian investors, you should buy when everyone wants to sell and sell when everyone wants to buy. You have to be in fundamental disagreement with majority of the other investors in the market. Going against the crowd is not easy to do, that is the reason why majority of the investors are not able to beat the performance of the market returns. Though, deviant thinking is difficult, it roved many times as a best style.

Don’t buy shares on prospect theory

It is proved over a period of time that an investor ignores bubbles because no one can afford for them to happen. So, a majority of the non-contrarian lives by over emphasizing on good news and ignoring negative news. This popularly known as prospect theory. To be truly contrarian you can stand up for the truth meaning which be realistic about any downside of an investment. Understand and recognise that it is our human tendency to be both overly optimistic and overly confident. Expect the worst to be much more severe than your initial projection and you do not have to act like a bitter.

Buys shares based on the relative ratios

Under this strategy you are buying shares based on the industry strength. The lowest price earning companies within an industry irrespective of how high or low the general price of the industry group. The plus point is that buying lowest values shares in each major industry opens a much larger investment universe. The relative contrarian strategy has more diversification by industry. Pick up companies that have greater than 20% discount to its peers. You can also use ratios such as price to cash-flow, price to book value, price to dividends, etc. So, you are buying good companies that are currently out of favour as measured by the above ratios.

Limitations

No investment style is free from limitations. The primary risk facing contrarian style investing is that it misread a stock potential which actually has further declines ahead and not gains. Secondly, one needs to have a strong will power to go against the crowd because of the lack of positive reinforcement for doing so.

Building an investment portfolio is similar to that organizing a cricket teams, you need a balance of different styles to complement each other. Like cricket teams, investors need to adapt different tactics or strategies such as being defensive, cautious or adventurous. Investors need to weigh up their investments’ qualities when building portfolio.

The writer is associate professor of finance & accounting,  IIM Shillong

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