Contrarian Investing: The Risks and Benefits

(MENAFN- Young And The Invested)

Contrarian investing has always been one of the most intriguing concepts in finance. Apart from its potential to deliver substantial returns for those willing to go against the herd, it has been the guiding principle of one of the world’s most successful investors, Warren Buffett, and the subject of one of the best finance movies ever made, The Big Short.

Rather than following the crowd, contrarian investors prefer to be lone wolves, scouring for opportunities behind unpopular, under-the-radar, out-of-favor, or undervalued assets. Contrarian investing is an idea that can help shape better investment decisions.

It is anchored in the belief that markets overreact to good and bad news, driven by either irrational exuberance during bubbles or panic and despair during downturns. These overreactions create openings for savvy investors to swoop in and capitalize on mispriced assets.

Columbia Business School Adjunct Professor of Business Michael J. Mauboussin once said in an interview with a finance blog that what differentiates a great investor from a good one rarely has to do with the tools they're using. Instead, investment excellence involves decision-making skills, especially during stressful situations. Furthermore, he believes enhancing decision-making is the best way to improve outcomes.

What is contrarian investing?

Contrarian investing is an investment style or philosophy that involves purposefully going against prevailing market trends—ergo, buying when other investors are selling and selling when they are buying.

When people say the market is increasing, contrarian investors believe they are fully invested and have used up most of their purchasing power. Hence, the rise of an asset's price is indicative that the market is at or close to its peak. Conversely, talk of a downturn implies that the investors have sold out. Thus, there is no other way for the market to go except up.

The principle of contrarian investing is based on the idea that markets are influenced by herding. Moreover, the herding behavior or bandwagon mentality is amplified by fear and greed. This strategy assumes that markets are periodically either over- or underpriced. Investors find opportunities in the "mispricing" coupled with proper information from careful research.

The Benefits: Why engage in contrarian investing?

Contrarian investing is a method that aims to beat the market. Far from the sensationalist way it is often portrayed, investing against the prevailing sentiment requires patience and discipline.

While the general idea seems simple, the strategy underneath needs a lot of research and finesse. However, when done right, contrarian investing can be a way to mitigate risk in a portfolio. It can also be a compelling long-term investment strategy. The following are the benefits of being a skilled contrarian investor:

Higher upside and returns

One of the prime benefits of this strategy is the potential for higher returns. Contrarians aim to find undervalued assets during downturns or periods of heavy pessimism. They then acquire them at a discount.

Investors benefit when the market sentiment eventually shifts. The purchased assets, assumed to be bought below their actual value,  may appreciate significantly, thus delivering higher-than-usual gains. As such, picks can take a long time to turn around; investors can explore contrarian stock picks or funds only as a part—not the whole—of their portfolio.

Resilience and independent thinking

Contrarian investing helps you avoid the madness of crowds. As an investment philosophy, it provides the groundwork for conducting thorough research rather than relying on consensus. As an investor, it cultivates your creativity, long-term focus, and investment conviction.

Mitigates risk

When done right, contrarian investing can offset risk in your portfolio. It is a viable risk mitigation strategy. By avoiding overhyped assets, you reduce the risk of getting into market bubbles. Contrarian investing is most effective at preventing the risk of speculative frenzies and irrational exuberance.

Contrarian investing shines the most in market panics, sector rotation, market bubbles, and sentiment extremes.

The Risks of Contrarian Investing

Since contrarian investing can generate considerable returns, it has risks and downsides. These risks could include:

Errors caused by information asymmetry

While a formidable weapon for contrarian investors, information asymmetry can lead to bias or investment mistakes, primarily when relying on inaccurate or incomplete data.

Timing errors

Some contrarian investors attempt to time the market. This move is challenging, and anyone inexperienced who does this is playing with a crystal ball. When you try to predict market reversals or shifts, you can end up in an undesirable position. Extended periods of underperformance can result in low returns for longer than anticipated.

Errors caused by behavioral bias

Behavioral bias can lead contrarian investors to make mistakes based on their thesis. Opposing trends for its own sake can lead to missed opportunities.

Reduced diversification

Contrarian investors may struggle to balance their portfolios because they tend to concentrate on out-of-favor assets. A lack of diversification based on their investment thesis can lead to higher risk.

Seize The Opportunity: Profit by Going Contrarian

Contrarian investing has risks and benefits. Carefully weighing both, you can use this principle to seize opportunities in the market. It may appeal to those with a higher risk tolerance and long investment horizon. Such investors have the patience to weather short-term market volatility and wait for their contrarian bets to materialize.

You can balance risk by conducting proper research and due diligence. Those willing to analyze vast quantities of information and try to uncover undervalued opportunities will profit the most. You can gain more conviction in your investment decisions by thoroughly understanding the underlying factors behind market sentiment.

Contrarian investing should not constitute your entire approach to investing. Instead, it is best suited to a well-balanced and diversified investment portfolio. By allocating some of your assets to contrarian strategies, you benefit from its advantages while avoiding or mitigating some risks. One way to do this is to reallocate capital from overvalued to undervalued assets.

By avoiding times of greed and adequately calculating the fundamental value of assets, you can learn to skip exuberant bubbles, see through the hype, and focus on assets at a historically low point. Contrarian investing takes time, but it is a valuable skill that aspiring investors should master.

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