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?
- Popularity Skews Valuation: Followers of contrarian investing believe that the valuation of stocks is not only influenced by cash flows but also influenced by other parameters such as popularity. This means that two investments can provide the same cash flow. However, if one of them is more popular, then it will have a higher price. Hence, the popular asset is often overvalued.
Hence, by extension, the unpopular one often remains undervalued. This means that popularity skews the valuation. Hence, contrarian investors try to keep track of the popularity of the stocks. They do so by following the newsletters of famous brokerage and investment firms.
The stocks with buy recommendations are given a certain number of points, and so are the ones with sell recommendations. Finally, the sum of all the recommendations is added up in order to create a popularity index. The least popular stocks are the ones that contrarian investors pick up for further analysis. They are only trying to find out the stocks which have good cash flows buy are undervalued because of lack of popularity.
- Unrealistic Forecasts: Another reason why contrarian investing works is because of the use of precise forecasts while valuing stocks. Most investors use precise forecasts while deriving future cash flows.
The problem is that forecasts used can almost never be precise. The future is highly unpredictable, and hence over time, the forecasts come to be known as unrealistic. This is why a lot of the stocks which seemed fairly valued all of a sudden seem over or undervalued.
Contrarian investing tries to take advantage of this sudden change in perception and the overreaction that follows.
Pitfalls of Contrarian Investing
Contrarian investing has several pitfalls, as well. Some of them have been written below:
- Difficult to Practise: First and foremost, contrarian investing is a difficult technique to follow. As we have seen that humans can be driven by emotions. Hence, it takes a lot of courage and conviction to do the exact opposite of what the entire market is doing.
Many investors start with contrarian investing. However, mid-way, they are overwhelmed by emotions and end up changing course.
- Chances of Failure: Contrarian investing is not a guarantee for success. The investing decisions made using this strategy can also be wrong and can end up causing a lot of damage to the investors portfolio. Sometimes, the hype may be real, and by trying to avoid the hype, the investor might end up avoiding a good investment.
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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- Behavioral Finance - An Introduction
- Heuristics and their role in Finance
- Advantages of Behavioral Finance
- Limitations of Behavioral Finance
- FAQs About Behavioral Finance
- Prospect Theory
- How Loss Aversion Affects Investment Decisions
- The Sunk Cost Fallacy
- The Endowment Effect
- Regret Aversion Bias
- Self-Control Bias
- Anchoring Bias in Behavioural Finance
- Confirmation Bias in Behavioral Finance
- Herd Mentality Bias
- Mental Accounting
- Recency Bias
- Overconfidence Bias
- Conservatism Bias
- Framing Bias
- Behavioral Portfolios
- Hindsight Bias
- Illusion of Control Bias
- Status Quo Bias
- Sample Size Neglect
- Optimism Bias
- Cognitive Dissonance Bias
- Home Country Bias
- Availability Bias in Behavioural Investing
- The Bias Blind Spot
- The Narrative Fallacy
- The Planning Fallacy
- Base Rate Fallacy
- Contrarian Investing
- Cultural Influences on Financial Decisions
- Behavioral Life Cycle Theory
- The Barnewall Model
- Bielard, Biel and Kaiser (BBK) Model
- Three Dimensional Pscychographic Model
- Categorizing Behavioral Biases
- Lessons Learned in Behavioural Finance