The world of investing is full of different strategies and approaches, each with its own advantages and disadvantages. One of the most intriguing and unconventional strategies is “contrarian investing.” This approach challenges popular wisdom and is based on the belief that markets often overreact to information, creating opportunities for investors who are willing to go against the grain. Here’s how it works.
What is contrarian investing?
Contrarian investing sounds sophisticated, but the basic idea is very simple. It involves investing against the grain… or against what the market seems to recommend. When prices drop, and markets are shaky, a bold contrarian strategy could translate into significant profits.
But you don’t need to wait for a crisis to show your contrarian side. It would suffice to buy shares that are currently down but believed to have potential. The difficulty lies in being able to identify these undervalued stocks. There’s something here, therefore, of value investing. But normally, the approach is more about going against the market. Why?
People tend to sell stocks that have recently performed poorly and buy those that are doing well. This reinforces market trends: the more a “hot” stock is bought, the more its value increases, and more investors want to buy it to avoid missing out. The contrarian strategy is based on having the right investments once market sentiment changes.
Examples of contrarian investing
One of the most famous examples of contrarian investing is the strategy used by Warren Buffett. Buffett often buys shares of companies that are experiencing temporary difficulties but have strong long-term fundamentals. A notable example is his investment in American Express during the salad oil scandal in the 1960s when the company’s shares were heavily punished.
Another example is John Templeton, who bought shares of Japanese companies after World War II when the Japanese economy was devastated. These investments proved to be extremely profitable as Japan recovered and became one of the world’s strongest economies.
Advantages of contrarian investing
The advantages of this strategy are clear: betting against the market can be very profitable.
- High-Yield Opportunities: By investing in undervalued assets, contrarian investors have the potential to achieve significant profits when the market eventually corrects its valuation.
- Diversification: Contrarian investing often leads to a diversified portfolio, as investors seek opportunities in sectors and assets that others avoid.
- Protection Against Bubbles: By avoiding overvalued assets, contrarian investors can protect themselves against market bubbles and drastic corrections.
Risks of contrarian investing
The main drawback of this strategy is that we might be wrong in applying it and invest against the market when it is actually correct…
- Market Timing: One of the biggest challenges of contrarian investing is getting the timing right. Identifying undervalued assets is only part of the challenge; the investor also needs to wait until the market recognizes the value of those assets, which can take a long time.
- Opportunity Cost: Investing in undervalued assets that take time to recover can mean missing out on opportunities in other assets that are generating returns.
- Risk of Incorrect Valuation: In other words, the risk of being wrong. Contrarian investors risk investing in assets that are undervalued for valid reasons, such as fundamental issues in the company or sector.
If it only had advantages, contrarian investing would be pointless. In fact, this strategy can be risky. We may overestimate our ability to identify “bargains” and expose ourselves to significant losses when we are wrong. Therefore, it is advisable to try and practice it only with a small portion of our portfolio to limit potential losses.
