Contrarians take the emotion out of investing to avoid the pitfalls common to the crowd. Learn more about the investments strategies of contrarians.
Contrarians follow investment strategies that run counter to conventional wisdom in an effort to achieve above-average returns. The stance can feel uncomfortable at times, but successful contrarians – most notably Warren Buffett – can beat the crowd by avoiding the pitfalls common to retail investors.
“Most investors think following the crowd is safer,” said Paul Merriman, writing for the website Fund Advice. “Our survival instincts tell us to protect ourselves with the ‘safety in numbers’ and that bad things can happen when the ‘weak get separated from the herd.’ These survival instincts may work well for animals, but they aren’t useful for investors.”
The investment strategies of contrarians are designed to spot companies that are over- or undervalued. According to Trading Online Markets, “Mispriced opportunities arrive when people let their emotions take control over logic and analysis. (See our related blog: Emotional Investing My Foot!) These situations offer good entry or exit opportunities to capture additional profits. When an opportunity presents itself, contrarian investors complete their thorough evaluation before they make a commitment.”
Contrarians focus on company metrics such as price-to-earnings, price-to-cash flow, price-to-book value and price-to-dividend rations, according to AAII, the website for the American Association for Individual Investors. They consider relative industry strength, as well as investor sentiment and market trends.
Widespread pessimism can lead the market to understate a company’s value, while widespread optimism can create excessive prices and bubbles. The website Contrarian Investor explains, “As investors we are over confident and we far too often make decisions based on our emotions rather than facts.”
The average investor realizes returns well below the market average, according to Contrarian Investor, which notes that in the 20 year period from 1990 to 2010, the S&P 500 returned 8.37 percent annually, while the average investor saw returns of 3.17 percent.
“Why such a poor performance for the average investor?” asks the website. “There are many explanations and they all link back to our behavioral biases and mental pitfalls. We all have biases and blind spots but it is easier to discover them among other people than ourselves.”
Contrarians try to take a rational approach to investing, tuning out crowd sentiment and analyzing company fundamentals to find stocks that are “currently unpopular but are likely to regain their luster,” according to Contra the Heard. The investment strategies require discipline, patience and emotional fortitude. Contra the Heard recommends that would-be contrarians carefully analyze management’s ability to achieve stated goals, seek a diversified approach and appreciate the benefits of dividend paying stocks, among other investment strategies. (For a contrarian diversification strategy read our related article on alternative mutual funds.)