The rise of behavioral finance has led to several new strategies being floated in the financial world. Contrarian investing is one such strategy. This strategy did not exist till most of the world followed the traditional cash flow based financial models. However, ever since behavioral finance has come to the fore, so has contrarian investing. There are several investors who have practiced this technique for the past two-three decades and swear by its efficiency in wealth creation. In this article, we will have a look at what contrarian investing is as well as how it impacts investor decision making.
What is Contrarian Investing?
Contrarian investing is an investing technique wherein the plan being followed by the investor is to do the exact opposite of what the market does. This investment philosophy has been derived from the famous quote by Warren Buffet, which says that one must be greedy when everyone else is fearful and be fearful when everyone else is greedy.
In a normal market, people seek recommendations from experts and then buy the shares which have been recommended by them. However, this is not the case when it comes to contrarian investing. In fact, as per this philosophy, investors actually keep track of the stocks which are being recommended by the experts and make an attempt to stay away from them. The underlying assumption behind this philosophy is that the retail investor is generally always wrong. Hence, attempts must be made to deliberately do the opposite of what the retail investor is being recommended to do.
Is Contrarian Investing a Behavioral Bias?
Contrarian investing can be an investment strategy or a behavioral bias based on how it is used. The reality is that contrarian investing is supposed to be a strategy that takes advantage of the biases that other people have. For instance, overconfidence, optimism, as well as representativeness bias, cause the valuation of some stocks to become irrationally high. If we follow the contrarian approach, then we can avoid this high valuation.
However, contrarian investing should only be used as an indicator. Just because an investment is not popular does not mean that people are overlooking its hidden potential. In many cases, the investment is not popular because it has poor fundamentals.
Hence, contrarian investing should only be used as an indicator, and other evaluations must also be done in order to identify an investment opportunity. If the contrarian investing philosophy is blindly used to do the exact opposite of what the market is doing, then it no longer remains a strategy but instead morphs into a bias.
Why Contrarian Investing Works?
Now, the next question which needs to be answered is why does contrarian investing work? Also, how can this technique be used to identify investment opportunities in real life?
Pitfalls of Contrarian Investing
Contrarian investing has several pitfalls, as well. Some of them have been written below:
The bottom line is that contrarian investing is a widely used strategy that takes advantage of the behavioral flaws in other investors. However, this strategy, too, needs to be followed carefully, or else it can also cause potential damage to the portfolio.
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