What is Contrarian Investing? All You Need to Know

What is Contrarian Investing? All You Need to Know | Finance | Emeritus

Have you ever pondered the reason why conforming to the majority frequently results in market disillusionment? The 1929 stock market crash serves as a remarkable illustration. Prior to the crisis, the prevailing sentiment, as evident in newspaper headlines, was predominantly optimistic. Notable individuals such as Yale economist Irving Fisher expressed unwavering confidence in equities being “permanently high”. Well-known periodicals like The New York Times and The Wall Street Journal repeated this baseless optimism. At the time, no one thought to take an opposing, contrarian investing point of view (which is what this blog is about!)

Nevertheless, this prevailing state of extreme happiness concealed fundamental weaknesses in the market. Shortly after, the bubble burst, leading to what is known as “black Tuesday”, the day the US stock market collapsed—a disastrous crash that caused significant losses for several investors. This historical occurrence highlights an important lesson: investor sentiment and current market patterns of the majority are not always trustworthy indications of future results. Unquestioningly adhering to the group can result in catastrophic outcomes.

However, what if there exists a technique that flourishes by actively questioning and opposing the prevailing investor sentiment? Contrarian investing is a method that involves making investment decisions that go against popular opinion, challenge established norms, and may seem counterintuitive to most people. This blog will explore the quirky phenomenon of contrarian investing, examining its fundamental concepts, successful tactics, and the advantages it offers in the financial markets. 

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Explanation of Contrarian Investing

Contrarian investing is an investment technique that is diametrically opposed to mainstream investing. Contrary to the majority of investors who tend to follow popular trends, contrarian investors purposefully go against the prevalent investor sentiment. Going against the grain, they often buy unpopular or undervalued assets during periods of others’ selling and sell when others buy. But why? And how? Let’s dig deeper. 

1. Contrarian Investing: Going Against the Herd Mentality 

The stock market is often driven by emotions and crowd psychology. Market peaks are typically characterized by extreme optimism, while bottoms are marked by extreme pessimism. The phenomenon of herd mentality leads to situations in which investors behave impulsively, succumbing to the influence of the majority rather than making well-thought-out choices.

However, contrarian investors excel in this particular situation. They acknowledge that when confidence is at its peak, liquidity is at its lowest, indicating a scarcity of buyers who can drive prices up. On the other hand, in a situation when there is widespread pessimism and everyone is selling, there is a large level of liquidity. This suggests that the selling pressure has reached its limit, and a bottom may be approaching. As Warren Buffett aptly put it, “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is.”

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Contrarian investors use this insight to their advantage. They seek out situations in which the general public is excessively hopeful or negative and thereafter adopt a contrary stance. This technique is founded on the premise that markets frequently exhibit inefficiencies and that emotions can cause prices to deviate from their intrinsic worth.

However, it is crucial to acknowledge that contrarian investing strategies are not merely about deviating from the norm without reason. As Martin Zweig cautioned, “The time to be wary of crowd psychology is when the crowd gets extraordinarily one-sided.”  Thus, it’s not just going against the current. Rather, it is about having a disciplined approach, conducting thorough research, and making informed decisions based on a deep understanding of the market and individual companies. Hence, contrarian investors must assess the situation and avoid blindly opposing the majority.

2. Key Principles of Contrarian Investing

A. Opposition to Market Sentiment

Contrarian investors buy assets that are out of favor with the majority. They believe that when the market sentiment is overwhelmingly positive or negative, the true value of assets gets distorted.

B. Focus on Intrinsic Value

Contrarian investors seek assets whose market prices are below their intrinsic value. They rely on fundamental analysis to determine the true worth of a stock, independent of current market sentiment.

C. Long-Term Perspective

Contrarian investing often requires patience, as it can take time for the market to correct itself. Investors must be willing to hold onto their positions for an extended period until the market recognizes the true value of the assets.

D. Risk Tolerance

This kind of investing involves significant risk. Going against the crowd can lead to short-term losses, and investors must have a high tolerance for volatility. They need to be confident in their analysis and resilient in the face of market pressures.

3. Warren Buffett and Amex: A Case Study in Contrarian Investing

A. The Scandal at AmEx

In 1963, the American financial world faced a massive fraud known as the “Salad Oil” scandal. Allied Crude Vegetable Oil used falsified inventory documents to secure substantial loans from various financial institutions, including American Express (AmEx). As news broke, AmEx’s stock price plummeted, with investors fearing significant losses and reputational damage.

B. Enter Warren Buffet

Amidst the panic, Warren Buffett, the renowned investor and chairman of Berkshire Hathaway, saw an opportunity. While others sold their AmEx shares, Buffett recognized that the scandal, though serious, did not fundamentally alter the company’s core business of traveler’s checks and credit cards.

In a classic contrarian move, Buffett began accumulating AmEx shares at a steeply discounted price. He invested approximately $20 million, amounting to a 5% stake in the company at the time. He famously remarked on the market’s reaction, stating, “Every trust department in the United States panicked… the market got slightly inefficient for a short period of time.”

Buffett’s bet proved remarkably prescient. AmEx weathered the storm, its core business continued to flourish, and its stock price eventually recovered and soared to new heights. Through subsequent share buybacks by AmEx, Berkshire’s stake steadily increased without further purchases. In 2022 Berkshire owned 151.6 million shares of AmEx, approximately 20% of the company. This contrarian investment has generated billions of dollars in profit for Berkshire Hathaway, making it one of Buffett’s most successful long-term holdings.

The “Salad Oil” scandal and Buffett’s contrarian investment strategies with regard to AmEx serve as a timeless lesson in the informed courage to go against the herd when the fundamentals align. Moreover, it is a reminder that even amidst market turmoil, opportunities can arise for those who dare to see them. 

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Rationale Behind Contrarian Investing

As already established, the rationale for contrarian investing lies in the belief that markets are not always efficient. Investor sentiment, driven by fear and greed, can cause prices to deviate from their intrinsic values. Contrarian investors exploit these deviations to make profits. When the majority of investors act irrationally, contrarians see opportunities for gains. They recognize that markets often overreact to news and events, creating mispriced assets ripe for investment. Some of the factors that give contrarian investing an edge are discussed below: 

1.  Market Inefficiencies

Markets are often subject to herd behavior, where investors follow each other without independent analysis. This herd mentality can lead to overpriced assets during booms and underpriced assets during busts. Contrarian investing capitalizes on these inefficiencies.

2. Fear and Greed

Emotional biases cause investors to overreact to market news, creating opportunities for contrarians. For example, fear creates buying opportunities as prices fall below intrinsic value. During times of panic, contrarian investors step in, buying assets that others are dumping. They rely on contrarian investment strategies to identify these moments, knowing fear-induced selling often leads to undervaluation.

On the other hand, greed leads to selling opportunities as prices exceed intrinsic value. When the market is driven by greed, prices can become inflated. Contrarian investors sell during these times, locking in profits before the inevitable correction. They sometimes depend on contrarian indicators to navigate their investment, ensuring they capitalize on the market’s irrational exuberance.

3. Recognizing Market Timing

Timing is crucial in contrarian investing. Investors must recognize when to enter and exit the market to maximize profits. They look for signs of market bubbles and short squeezes to inform their strategies. Understanding these market dynamics allows them to make timely investments.

4. Utilizing Market Indicators

Contrarian indicators play a vital role in this strategy. Indicators such as excessive pessimism or optimism help contrarians gauge market sentiment. By tracking these indicators, contrarian investors can identify when the market is likely to reverse, allowing them to make strategic buys and sells.

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Advantages of Contrarian Investing

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Contrarian investment strategies offer distinct advantages that stem from its ability to capitalize on market inefficiencies and deviations from rational investor sentiment.

1. Identification of Mispriced Assets

Contrarian investors actively seek out assets that are undervalued or overvalued due to prevailing investor sentiment or herd behavior. This approach allows them to acquire assets at a discount or sell them at a premium, generating alpha (excess returns) compared to the broader market. 

2. Long-Term Focus and Patience

Contrarian investing often necessitates a long-term perspective, as the market may take time to correct its mispricing of assets. Investors who exercise patience and remain committed to their contrarian investment strategies can potentially reap significant rewards when their thesis eventually plays out.

3. Capitalization on Market Corrections

Such investors actively profit from market corrections, such as bear markets or sector-specific downturns. By buying assets when others are panic selling, they position themselves to benefit from the eventual recovery and subsequent price appreciation.

4. Exploitation of Market Bubbles

Contrarian indicators, such as extreme levels of optimism or pessimism, can help identify market bubbles, where asset prices have become detached from their fundamental value. By recognizing and acting on these contrarian indicators, investors can potentially avoid losses and even profit from the eventual bursting of the bubble.

5. Diversification Benefits

Contrarian investing can offer diversification benefits to a portfolio, as it often involves investing in assets or sectors that are out of favor with the broader market. This can reduce overall portfolio risk and enhance returns, especially during periods of market turbulence or short squeezes.

Value Investing & Contrarian Investment

Contrarian investing and value investing are kindred spirits in the financial world, both seeking undervalued treasures in the market. Contrarian investors thrive on exploiting negative market sentiment and behavioral biases, swooping in when others are fearful to grab discounted assets. Value investors, meanwhile, meticulously analyze a company’s fundamentals, hunting for stocks trading below their intrinsic worth due to market overreactions. While both strategies share a long-term outlook and a belief in market corrections, their emphasis differs.

AspectsContrarian InvestingValue Investing
FocusUndervalued assets are neglected due to negative market sentiment or temporary setbacks.Stocks are priced below intrinsic value, as revealed through thorough fundamental analysis.
EmphasisMarket sentiment, behavioral biases, and contrarian indicators.Fundamental factors such as financial health, earnings potential, and competitive advantage.
StrategyBuying during market downturns or when a company is out of favor, selling when optimism is high.Buying undervalued stocks with solid fundamentals and holding for the long term until the market recognizes their true value.
Additional ConsiderationMay involve profiting from short squeezes after identifying market bubbles using contrarian indicators.May not explicitly incorporate market sentiment but primarily focuses on a company’s inherent worth and future growth potential.

Despite advantages, contrarian investing strategies do involve certain limitations and risks, such as: 

1. Mistiming Market Shifts

Contrarian investing carries the risk of mistiming market shifts. When contrarians buy undervalued assets, the market may not recognize their true value immediately. This delay can lead to short-term losses, testing the investor’s resolve. Market fluctuations can be unpredictable, and even the most thorough analysis may not perfectly time its movements.

2. Demands Patience

Contrarian investing demands significant patience. Investors must prepare themselves to hold their positions for extended periods, waiting for the market to recognize the intrinsic value of their assets. This patience is crucial, as rushing to sell prematurely can result in missed opportunities for gains. Contrarian investing often emphasizes the importance of a long-term perspective to achieve desired results.

3. Discipline and Uncertainty

Maintaining a disciplined stance is essential in contrarian investing. Investors must stick to their strategies despite market pressures and emotional biases. However, uncertainties and market fluctuations pose inherent challenges. Investor sentiment can remain negative for longer than expected, making it difficult to stay committed to contrarian positions. A disciplined approach helps navigate these uncertainties.

4. Short-Term Underperformance

Contrarian investors may experience short-term underperformance as the market corrects itself. This underperformance can be discouraging, especially when mainstream investments appear to be thriving. Contrarian indicators help manage this risk by providing signals of potential market reversals. However, patience and resilience are necessary to endure these periods of underperformance.

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In conclusion, contrarian investing stands out by defying the common market sentiment. It involves purchasing undervalued assets when the market is gripped by pessimism and selling when the market is overly optimistic. This approach relies heavily on understanding investor sentiment and identifying market bubbles. Utilizing contrarian indicators and capitalizing on anomalies like short squeezes, investors can uncover hidden opportunities. However, this strategy best suits those with a long-term perspective and a high tolerance for risk.

Ready to challenge the market norms and refine your investment strategies? Explore Emeritus’ finance courses and transform your approach to investing. Dive into advanced financial concepts that can reshape your portfolio and enhance your market insights.

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Content Writer, Emeritus Blog
Sanmit is unraveling the mysteries of Literature and Gender Studies by day and creating digital content for startups by night. With accolades and publications that span continents, he's the reliable literary guide you want on your team. When he's not weaving words, you'll find him lost in the realms of music, cinema, and the boundless world of books.
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