When we look to some of the most successful investors in Wall Street history it’s all but impossible not to come across some wildly successful contrarians. But what exactly does it mean to be a contrarian investor? This article dives deeper into the topic, examining the contrarian approach in greater detail and to whom it might appeal.
What Is Contrarian Investing?
Contrarian investing is a strategy defined by buying (or selling) in opposition to the prevailing sentiment of market participants at the time. Contrarians will often buy those assets that are “most hated” and look to stay away from (or even short-sell) those that are “most loved” by the majority of the crowd.
In contrast to momentum investing, the contrarian strategy looks to go against the trend, and for that reason is more synonymous with value investing.
For a deeper understanding of what it really means to be a contrarian, it pays to learn more about the history of this investing style. Read more about the investing careers of some notable contrarians, such as David Dreman, Jim Rogers, Warren Buffett, Sam Zell, Sir John Templeton, and George Soros (just to name a few).
The Appeal, Risks and Nuances of Contrarian Investing
Contrarian investors like Warren Buffet are famous because they are wildly successful in exploiting market inefficiencies. After all, any successful strategy in the market is fundamentally tied to “profiting from the crowd.” In that regard, contrarian investing is no different than, say, value or momentum investing.
While it is more difficult to quantify and back-test than value and momentum-based strategies, the contrarian approach is supported by historical data that emphasizes its appeal. Consider the following from AQR Capital Management, courtesy of Institutional Investor:
In summary, research suggests that following a strategy based around contrarian timing signals, in lieu of buying and holding, may yield outsized gains over time.
Drawbacks of Contrarian Investing:
There is an ugly side to this oft-cited, and equally misunderstood, investing strategy. The truth is that being a contrarian is just plain difficult. Most investors will never overcome their own biases, let alone learn how to consistently profit from these behaviors in others. Furthermore, being a contrarian requires tremendous patience and a stomach for volatility, two qualities that few investors truly possess when all is said and done.
Read more about Battling Your Investing Biases.
Contrarian Indicators 101
Here’s a list of some of the most popular indicators that investors look to for contrarian signals:
- ETF & Mutual Fund Flows
- Volatility Index (VIX)
- Put/Call Ratio
- AAII Sentiment Survey
- NYSE Margin Debt
- Commitment of Traders Report (CoT)
Read more about contrarian indicators ETF investors must know.
Developing a Contrarian Strategy
At its core, contrarian investing is about profiting from the overreaction of others. But it’s not as simple as buying the losers and selling the winners.
Contrarian Checklist:
It helps to have a number of contrarian signals, of different origins, align before pulling the trigger.
- What are the fundamentals? Think valuation indicators.
- Does the chart setup suggest now is a good time to buy?
- How does the rest of the market feel about this security? The more extreme the sentiment, the better.
- What will move the rest of the market to realize they are wrong (and you’re right)? There must be a catalyst on the horizon, otherwise your contrarian pick is likely to drift nowhere. Being patient is one thing, being wrong about the reason you bought something is entirely different.
The point here is that the ideal contrarian trade often has to meet more than one of the above criteria. You shouldn’t rush into buying a security just because it is beaten down, hated by the crowd, and appears to be way undervalued; there must be something else, hence a catalyst, which can drive the reversal in sentiment and fundamentals.
How to Be a Contrarian With ETFs
There is only one ETF that bears the “contrarian” label, and that is the PowerShares Contrarian Opportunities Portfolio (CNTR ). With that being said, investors can still pull off the contrarian approach any number of ways by following the principles of discipline and some of the suggested tips in the section above.
Use the ETFdb Screener to narrow down your product list once you have started your research.
The Bottom Line
Don’t be quick to assume you know everything about being a contrarian investor; it’s a lot more difficult than just buying what everyone else is selling. Take the time to read more about contrarian investing to uncover whether this approach is right for you. While it has proven to generate outsized returns over time for many, the contrarian approach requires nerves of steel as well as a long-term horizon.
Follow me @SBojinov
