Are you a contrarian investor?
October 13, 2021
6 minutes to read
One of the first questions that new investors often ask themselves is: should I invest in the shares that "everyone" buys, or go for the shares that "everyone" dumps?
It’s a smart question. In the first case, you think it likely that the majority will get it right. You simply do the same as the rest: buy when the trend is positive, and sell when the trend turns negative. In the second case, you buy when the shares are down, assuming that the shares have been punished too severely and that other investors will work this out sooner or later. Once the shares pick up again, you sell them.
Besides following the trend or investing contrarily, there is also a third strategy: do nothing.
1. Contrarian investing
If you are a contrarian investor, you fly in the face of popular beliefs and general stock market sentiment. If "everyone" is buying, it’s time for you to sell. And when "everyone" is selling, you do the exact opposite. If you bought shares massively when the stock markets plunged in March 2020, then you were investing contrarily.
You can apply the principles of contrarian investing to individual shares, to a whole sector, or even a complete market. Investors who practise this style understand that stock market hypes and trends can be misleading. Sometimes shares can be talked up and feted so far that they lose touch with reality. When investors are optimistic about a share, then a contrarian investor is pessimistic. Or at least cautious.
Conversely, contrarian investors often rush in where others are pessimistic. At that point, a contrarian investor believes that the negative sentiment among other investors is pushing share prices down below their real value, creating a good buying opportunity. A contrarian investor will then buy as many shares as possible before "sanity" returns and the shares go back up to a price that reflects their real value. Contrarian investors swim against the tide and believe that sentiment is not a good guide.
Warren Buffett is perhaps the most well-known contrarian investor. One of his slogans is be fearful when others are greedy, and greedy when others are fearful. This approach did him no harm. Between 1965 and 2020, the average annual return of his holding company, Berkshire Hathaway, was 20%.
Contrarian investing seems to be a smart mindset: you buy when others are selling and sell when everyone is rushing to buy. But there is one big problem: timing. How do you know when a share is cheap and when it is expensive? The share price can easily drop by half or rise higher. Perhaps you can guess right now and again, but can you do it ten times in a row?
2. Following the trend
If you follow the trend, you buy when prices are rising and sell when they are falling. There is no hidden trick or magic formula to this strategy. The aim with this approach is to keep monitoring the market for any upward or downward trends.
Investors who adopt this style usually enter the market when they know that the trend is well-defined and that it will continue for a long time. However, as soon as they see a clear reversal in the trend, they will leave and wait for prices to return to their original level. As the saying goes, the trend is your friend until the end when it bends.
Investors often use technical tools to determine the direction of the trend. For this they watch price movements on graphs. By identifying patterns, they try to estimate the future price trend. Technical analysis requires a lot of expertise and homework. And while it can be a useful tool, it’s certainly not a silver bullet.
Other investors do not use technical analysis, but simply ride with the sentiment. That’s their way of investing with the trend. Are gold mine shares doing well at the moment? Then buy shares in gold mines. Are gold mine shares doing less well? Then dump gold shares. Of course, the timing issue is a problem here. After all, when is a trend well-defined? There is always a risk that you will jump on or off the bandwagon too late.
3. Do nothing
Doing nothing looks like a lazy solution. However, there are arguments in its favour. If you do nothing, you leaver your investments to the moods on the stock market. When should you buy in and when should you sell off? These questions are then no longer relevant. Check your investments every day? No need.
If you do nothing, your investments will fall when the market does poorly, but they will rise when the market performs well. Your investments therefore perform no better than the market, but also no worse. That doesn't have to be unfortunate, because historically, stock markets rise over the long term (even if you include all the crashes). Over the past 121 years, a diversified equities portfolio would have yielded on average 5.3% per year (allowing for inflation).
It’s also good to know that many of the best days on the stock market follow hot on the heels of the worst ones. And you certainly don't want to miss those best days. Imagine that you had invested in the S&P500 over the past 90 years. If you missed the best 10 days in every decade, you would have achieved a return of 28% after 90 years. If you didn't do anything – just held onto your investments for 90 years – you would have had a return of 17,715% (seventeen thousand seven hundred and fifteen percent!). Simply staying invested, not constantly exiting and entering, seems a smart choice over the longer term.
The chance that you would stay invested for 90 years is, of course, small. But the "do nothing" principle also works in the shorter term. However, two things are essential:
- Ensuring adequate diversification. For example, by investing in index trackers or funds that are made up of hundreds of different shares.
- Going for the long term. This means at least 5 to 7 years if you invest in shares. The longer you invest and remain invested, the more time the market will have a chance to pick up if you had the bad luck to buy in at the wrong time.