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Contrarian Investing – Pros and Cons of it

Published: Tuesday, November 29, 2011, 16:42 [IST]

Contrarian Investing – Pros and Cons of it

Contrarian, as the word implies, is the quality or the preference for taking a position against the majority or the crowd. It is typically associated with rebellion or dissent. In stock market, the meaning is different. A contrarian investing is an investing style which advocates taking position against the crowd.

Hence when the crowd panics and start selling, the contrarian investor enters for buying. Similarly when the crowd starts buying, the contrarian investor starts selling. It is very similar to what Warren Buffet says “be fearful, when others are greedy and be greedy when others are fearful”.

Contrarian Investing – A primer
Why do contrarian investors go against the crowd in the investing world? Aren’t we taught about the “wisdom of the crowd” or “efficient market theory” where the crowd’s decision is right and market prices the stocks correctly?

The markets are efficient when it comes to pricing stocks and crowd is generally right about its behaviour. However, these hypotheses are true in long term. Market does mispricing and crowds do exaggerate the situation in the market in short term. This is where the contrarian investors step in and exploit the short term gaps crated by the market in pricing stocks. This mispricing because of crowd behaviour in short term is what keeps contrarian investing such an attractive proposition.

Notes from the Dalal Street
Take the crash of 2007-2008. The fear was magnified because the crowd got panicky after Lehman’s collapse, slowdown in US market, and crashing of few banks in western countries. These events created good short term mispriced equities in the market. Contrarian investors invested in such times and by 2009 end, they made good money because by that time market realized its folly and corrected it by bringing some of the stocks at prices equivalent to the prices before the crisis. ICICI bank came down to 300+ because market magnified the impact of US crisis on Indian banks. Infosys came down to below s 1500 because market magnified the impact of US slowdown on IT companies.

Recently too, we can see the similar trend when Sun TV stock was beaten down because of regional politics of tamilnadu. The stock saw extreme fluctuation in a matter of few days.

Pros and Cons of contrarian investing
A contrarian investor goes against the crowd. It takes extreme guts and faith in one’s ability to be a contrarian investor. If you have faith and enough guts, nothing is impossible. However, you should understand the pros and cons of contrarian investing style.

Pros –
Contrarian investing can be extremely rewarding experience. Usually market magnifies events that impact stock prices. A sane investor following the philosophy of contrarian investing can take advantage of the situation and can make good money.

Contrarian investing also keeps the sanity in the market. When everyone is selling, contrarian investors buy in hordes and balance the market. Similarly when everyone is buying into the eternal bullish market story, contrarian investors keep a tab on the irrational exuberance by offloading their shares.

Cons –
There could be times when crowd dumping a stock is for good reason. There could be concrete information about revenues expected to go down or margin expected to face severe strain. In such cases, blindly following contrarian investing strategy can backfire. Hence investors should know the underlying reasons behind the fluctuation in prices. The point here is that there could be multiple reasons why stock prices go up and down. One of the reasons is pledging of shares by the promoters.

This news does not come in media very often. Hence investors have to be pro-active in tracking such news in order to become a successful contrarian investor.

Price of stock is a different phenomenon. The rise and fall in prices needs to be monitored closely by the investor. There can be situations when the rise fall in prices did not match with the news.

Understanding the correlation between price fluctuation and events requires expertise that will come by trading for a long time. It is very difficult to learn this by being in market for a few quarters or years. Hence a new investor or investors with less experience may lose money in this strategy.

Finally
Contrarian investing requires more than just going against the crowd. The crowd behaviour in the market is generally right. It is only in short term that crowd behaviour exaggerates the events impacting the market and creates mispricing. Learning to understand mispricing is the key.

InvestmentYogi

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