Contrarian Investing uses an investing methodology that is based on the principle of ‘rationality’. To be a rational investor, there is a need to be realistic about both the upside and downside to any investment. An investor must first recognize the tendency to be both over-optimistic and over-confident in his or her investment decisions. An investor must also recognize the tendency to over-rely on so called ‘experts’ for investment decision making.
The Contrarian methodology is rational because it attempts to determine if an individual company, industry or even an entire market is over-priced (irrational exuberance) or under-priced. A contrarian remembers that there were large periods of time in history in which investors received little or no return for being invested in the stock market.
The Association’s methodology is ‘contrarian’ because it disagrees with the efficient market hypothesis. The efficient market hypothesis states that stock prices reflect everything known about a company, an industry or an economy. Efficient market hypothesis states that stock prices cannot be predicted and that nobody can beat the market over time. Conversely, Contrarians believe that the market can be beat, by simply keeping a rational investing viewpoint: Contrarians control internal optimistic and pessimistic feelings and are independent thinkers.
Technical Analysis and Charting?
The Association’s methodology is ‘contrarian’ because it disagrees with technical analysis and charting techniques. If the efficient market hypotheses were to be true, technical analysis and charting would not be useful in predicting stock price movements because the current price would always be based on the current situation of the company. If the efficient market hypothesis were to be false, technical investors would believe that by studying charts and indicators, they could accurately project past performance into the future. Not too smart. A contrarian believes that forecasting cannot accurately been done.
The Association’s methodology is based on one simple principle: people over-react. This tendency to over-react can be seen daily –at work, at home or even on vacation. People are highly emotional creatures –- especially when it comes to love and love for money.
The same holds true for investors: investors over-react. Investors over-react to both good and bad news. There is an internal psychological pendulum in people that moves between optimism and pessimism.
Investors overprice the “best investments” as can be seen in the latest technology bubble, and under price the “worst investments”. This will be shown in our examples later.
Investors are simply too optimistic about stocks that appear to have good prospects.
Investors are simply too pessimistic about those that have so-so outlooks.
Contrarian Strategy Execution:
One of the most difficult aspects of a contrarian strategy is the strategy’s execution. As investors, we face uncertainty when we invest our capital. It represents our savings and our financial security. An investor suffers the ultimate consequence of an erosion of capital when a bad decision is made.
The success of a contrarian investing strategy requires the investor to go against gut reactions, and against the prevailing beliefs in the general market. Going against thecrowd, is not easy to do. This is why most investors don’t do it. But this is also why most investors and financial managers do not beat the performance of the market index. Most of us are influenced by societal pressures (co-workers, friends, family) that encourage the social norm. Deviant thinking from the norm is difficult because of the lack of positive reinforcement for doing so.
The reality is that a contrarian strategy takes time, discipline and patience — and most investors will give up on contrarian investing in the short run because there is optimism somewhere else in the market. Most people are drawn towards exciting new concepts and ideas with a hope for an investment home run. This home run approach is just not realistic as can be seen in the latest technology bubble and burst.
Still, most investors who try contrarian investing will simply not be able to stick it out for the longer term, because of these optimistic and pessimistic psychological influences.