There are investors whose main approach to investing is to go against the tide. Their opinions are unpopular, and their decisions are quite unorthodox compared to the greater consensus. These investors essentially swim against the current of market sentiments. Nevertheless, in selecting which companies or securities and assets to invest in, their options are non-mainstream. This approach is called a contrarian investment strategy or a contrarian approach to investing.
Contrarian Investing 101: Definition, Principles, Examples, Advantages, and Disadvantages of a Contrarian Approach to Investing
General Definition
A contrarian approach to investing is specifically an investment strategy. It centers on going against the herd mentality that pervades the involved markets. For example, when a particular market is brimming with optimism and most investors are rushing to invest, contrarian investors do the opposite. They believe this widespread enthusiasm can result in the overvaluation of involved securities or assets. Hence, as a contrarian response, methodically look for opportunities to buy when pessimism is high and prices have fallen out of favor.
The core idea behind a contrarian investment strategy is that the market can be influenced by emotions. This leads to mispricing. Nevertheless, by investing in less popular assets that seem undervalued, contrarian investors hope to profit when the market corrects itself and recognizes the true worth of these investments. This core idea is also similar to some of the general principles of value investing and individuals who prefer buying and holding value stocks. Warren Buffett and Charlie Munger are generally considered contrarian investors.
Key Principles
Remember that contrarian investors invest when others are fearful and step back when most are enthusiastic. They are essentially market skeptics. Nevertheless, to understand further what contrarian investing is, it is also important to understand the central tenets or key principles behind this approach in investing. These principles also correspond to the characteristics of a contrarian investor. Take note of the following:
• Disregarding Market Sentiments: Contrarian investors are skeptical of prevailing market trends and often ignore widespread market sentiments. They believe that popular opinion often leads to emotional investing and overreacting which further results in mispricing of assets. These investors are independent thinkers.
• Finding Value In Unpopularity: These investors also seek out assets that are out of favor with the market. This involves researching the underlying fundamentals of an asset like its financials, competitive advantage, and long-term growth potential. They believe that some undervalued assets have the potential to generate higher returns.
• Strong Focus On Intrinsic Value: Another principle of contrarian investing is its focus on intrinsic value. The intrinsic value of an asset is its true worth which is independent from its market price. Contrarian investors believe that market prices can deviate significantly from this true worth due to emotional reactions and herd mentality.
• More Than Timing The Market: It is true that a contrarian approach to investing often involves buying assets during downturns. This is not the case most of the time. Contrarian investing is not about blindly betting against the market. It is about thorough research to determine investment opportunities with a strong long-term outlook.
• Long-Term Investment Focus: Contrarian investors are patient. Another key principle of contrarian investing is that it adheres to some of the principles of value investing and it practices a buy-and-hold approach to investing. Contrarian investors are comfortable with holding onto their investments until the market corrects itself.
• Above-Average Risk Tolerance: It is also important to underscore the fact that contrarian investing is inherently risky. Contrarian investors must be comfortable with short-term market volatility since they invest in unpopular assets. They also understand that there is still potential for losses or unsatisfactory investment gains.
Advantages and Disadvantages
Embracing the principles of contrarian investing to become a true-blue contrarian investor has its merits. Remember that investors like Warren Buffett and Charlie Munger have demonstrated the value of having a contrarian approach to investing. It can be an ideal investment strategy for certain people. The following are the specific advantages of contrarian investing:
• Potential for High Returns: A contrarian investor has the potential to earn significant profits by investing in undervalued assets and when the market eventually corrects itself and recognizes the instinct value of supposedly undervalued assets.
• Market Outperformance: There is also a higher potential for contrarian investors to outperform the market and indexes or benchmarks over the long term by avoiding the euphoria and panic that often drive market bubbles and market crashes.
• Possible Reduction in Risks: It is also worth noting that investing when pessimism is high often means acquiring assets at discounted prices. This creates a margin of safety and gives contrarian investors an advantage over market-driven investors.
• Other Strategies Alignment: Another advantage of contrarian investing is that it can be aligned with other investor strategies. Remember that it also has some of the principles of value investing. It can also be attuned to the principles of defensive investing.
The advantages of a contrarian approach to investing seem to make it an ideal strategy for most. However, because it requires patience and above-average risk tolerance, it is not for everyone. It is specifically not suitable for investors looking for short-term gains or those who prioritize capital preservation. The following are the specific disadvantages of contrarian investing:
• Requires Extensive Research: One of the main disadvantages of contrarian investing is that it requires conducting thorough research. An investor must be familiar with fundamental analysis and other techniques needed to determine undervalued assets.
• Often Involves Higher Risks: It is true that contrarian investing can reduce some risks but it is still inherently a high-risk investment strategy. The risks come from the need to hold onto the investments for extended periods until market correction.
• Requires Long-Term Patience: Remember that contrarian investing requires patience. This makes it unsuitable for individuals with shorter investment horizons. This also makes it not ideal with a short-term-focused growth investment strategy.
• Key Psychological Challenges: A contrarian investor must be strong-willed. Going against the crowd can be emotionally challenging. This is especially true during a period of market downturns or when the market is on an upswing.