We have often wondered who is a contrarian and how does being a contrarian pay off. Well, it not always does, but when it does, the pay offs are high.
Let us understand who a contrarian is. Being a contrarian simply means thinking and doing things in an unconventional way. It involves taking steps which are quite contrary or opposite to what most of the people are doing.
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In terms of finance and investing, contrarian is an investment style which goes against the current market trends. They essentially buy the stocks when the others are selling and sell them when others are buying. According to the contrarians, when the market is constantly going up, it is soon going to reach a stage from where the downturn will begin, and when the market is going down, it will soon bottom out and start going up.
Being a contrarian is the extreme opposite of being the herd-follower. The investors with herd mentality follow the trends blindly and do exactly what the other investors are doing- they sell when others are selling and buy when others are buying. On the other hand, the investors with contrarian approach always go against the herd-they buy when others are selling and sell when others are buying.
The details of being a contrarian and its benefits and drawbacks are explicitly explained by Edgar Wachenheim III in his book, “Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor.”
Edgar talks about the psychology behind being a contrarian. He says,
Because at any one time the price of a stock is determined by the opinion of the majority of investors, a stock that appears undervalued to us appears appropriately valued to most other investors. Therefore, by taking the position that the stock is undervalued, we are taking a contrarian position—a position that is unpopular and often is very lonely. Our experience is that while many investors claim they are contrarians, in practice most find it difficult to buck the conventional wisdom and invest counter to the prevailing opinions and sentiments of other investors, Wall Street analysts, and the media. Most individuals and most investors simply end up being followers, not leaders.
It is true that being a contrarian takes a lot of courage. It is a place where you are standing alone, with no one supporting your views and opinion. The popular beliefs may term contrarians as rebels or over smart, however, being a contrarian is not about being a rebelling teenager. It is about avoiding the stupidity of following the crowd, avoiding the common mistakes, and challenging oneself to think more, think better and think unconventional.
In fact, I believe that the inability of most individuals to invest counter to prevailing sentiments is habitual and, most likely, a genetic trait. I cannot prove this scientifically, but I have witnessed many intelligent and experienced investors who shunned undervalued stocks that were under clouds, favoured fully valued stocks that were in vogue, and repeated this pattern year after year even though it must have become apparent to them that the pattern led to mediocre results at best.
It is rightly said that risks and rewards go hand in hand. The investor with the herd behaviour does not take much risks and therefore ends up with mediocre rewards. But the contrarian takes very high risks and, therefore, has a very high probability of receiving more than average rewards.
One such example is a gentleman with whom I periodically dine to discuss investment ideas. I will call him Danny Dinner Date. Danny has a high IQ and has been in the investment business for more than 40 years. He graduated near the top of his class from a rigorous private high school and attended an Ivy League college. He worked for many years as a securities analyst and portfolio manager, and eventually headed up a sizeable investment management company. Danny’s resume is A+. Yet Danny’s investment results are only mediocre—maybe C or C+. Danny will listen intently when I describe an undeservedly depressed stock that likely should appreciate sharply in response to the expected easing of a temporary problem, and he frequently will appear interested in purchasing the stock. However, in follow-up conversations, Danny often will mention that he is waiting for some signal that the problem has eased before purchasing the stock. Of course, by the time such a signal becomes apparent to Danny Dinner Date, it is likely that the easing already has become apparent to many other investors and that the price of the shares already has discounted part or all of the forthcoming change. Danny, therefore, is prone to purchasing stocks that already have appreciated sharply. Because Danny is fully aware of his mistiming, I readily conclude that his inability to purchase stocks that are under a cloud is habitual. He simply lacks the ability to be a contrarian leader and instead becomes a follower of the herd.
Thus, when the look of the market is clear, whether it is bullish or bearish, taking an investment decision is easier; but it is equally visible to all the participants and the rewards get distributed and hence reduced. The contrarian tries to look for signals when they are not clearly visible and acts on them, without any surety or guarantee of the move happening. He takes risks and the rewards in this case are concentrated only for the contrarians.
It is, therefore, rewarding to be a contrarian because most people don’t know how to think, and even when they think, they go with the principle of least effort and skip to conclusions. Such mediocre thinking and conventional wisdom only leads to average results and never success, unlike being a contrarian.