Most investors buy when the market is bullish, and sell when the market is bearish. As these sayings go: jump on the bandwagon and ride the wave; make windfall profit when times are good; and cut losses when times are tough.
Following the trend is a simple investment strategy, since market sentiments is usually assumed a good indicator in showing the market’s direction.
However, there are some investors who like to swim against the current when it comes to their investment, and they are known as contrarian investors.
What is contrarian investing?
By definition, contrarian is an investment strategy that goes against the prevailing market by buying assets when they are performing poorly, and selling when they are performing well.
Contrarian investing is also similar to value investing, a popular strategy where such investors look out for mispriced undervalued stocks that have good fundamentals or intrinsic value and buying it at a discount.
Contrarian methodology works like this: it is presumed that the general market participants are wrong because they may be easily swayed by market fluctuation and market bubbles, and they panic easily when the bubble bursts. As a result, they buy and sell at the worst possible times. This is also known as the herd mentality.
By simply doing the opposite, contrarian investors can exploit such opportunities by buying and selling at the right time, which in return make a killing when everyone else suffers losses.
“Sell high, buy low” is easier said than done. Following the herd (or trend) is simply human nature in action. So, what dictates contrarian beliefs and why they think against the crowd?
1. If it is on the news, it is too late
Market prices constantly adjust in sub-seconds. By the time reporters pass the information to news editors to be published, chances are the market prices have already changed.
2. Word of mouth
Not surprisingly, many inexperienced investors relied heavily on the advice of their family and peers while buying stocks.
These investors are usually inexperienced who pumped their life savings to particular company without any knowledge of its performance or the economy outlook, or young investors who aspire to be the next multi-millionaire in an instant, or just lazy people who think following the trend is good enough in making an investment decision.
Chances are, these investors invest without doing their homework first, and they make up the majority of the market participants, hence distorting and misleading the market direction. This results in mispricing of stocks and contribute to price volatility to a certain degree.
A good example is the recent oversubscribed and heavily traded penny stocks that neither has value creation or real sustainable growth prospect. Despite being strongly discouraged by financial analysts and also various trading restrictions imposed by brokerage firms, many investors followed the trend anyway hoping to make quick gain from it.
Chances are, such penny stocks that have no fundamentals are likely to crash leaving investors penniless.
3. People are overly optimistic during a bubble, and overly pessimistic during a slump
Time and again, history repeats itself. After the 1998 Asian Financial Crisis (AFC), the Y2K dotcom bubble burst and the 2008 Global Financial Crisis (GFC), little was learned from the mistakes by many investors, as experts expect another bubble to burst (the Malaysian property bubble).
One of the many theories that explain such phenomena is Prospect Theory, also known as the “loss-aversion theory”. The idea is that we make decisions based on perceived gains instead of perceived losses through heuristics and personal experiences.
For instance, in gambling we think that we will keep winning during a winning streak, or stop playing after losing a round or two. This is because we perceive wins and losses differently: a gain of RM100 is not as much as a loss of RM100.
This is especially true for those who have a stake in the investment, like those who refinance their property to take up another mortgage. They would be in denial even amid warnings from experts of a bubble burst, until it is too late.
Simply put, we are not as rational as we think we are.
How it works
As the saying goes, what comes up must go down and vice-versa.
The recent oil price slump that sent our Ringgit to five-year low and local oil producing stocks, like Petronas, to suffer from huge paper losses.
Panicked foreign investors are scrambling to dump our nation’s sovereign bonds, which drove the bond prices lower and the yields (returns) higher.
Hampered exports have also led to currency traders selling our Ringgit, not to mention the recent AirAsia tragedy have also caused the shares to plummet.
While others see this event as market calamity, contrarian investors see this as an opportunity to buy at a discount. With enough research and homework done, contrarians believe that shares with the right fundamentals will bounce back up in time, thus making a gain from it.
What are the limitations?
Contrarian values are sound, but there’s no such thing as a sure win investment strategy and contrarian has its flaws too.
1. The crowd is actually right
Though the trend alone is not a good indicator of the market’s direction, but it can sometimes be right too. If contrarians go against the crowd when they are actually right, huge losses are bound to be suffered by them.
There’s a fine line between people’s expectation and actual action too. For example, if the market is bullish but people expected the market to collapse, they will not buy. Contrarians who are trying to sell will then find themselves with no buyers.
2. Enough contrarians will make a trend
If by simply going against the crowd makes returns, everyone will be doing the same. When there are masses adopting a contrarian investment strategy, soon enough a reversal trend is created and the initial purpose of going against the trend is defeated.
This creates a contradicting fallacy, and could lead contrarians into a vicious cycle of chaos and confusion.
3. Stock volatility
In finance, beta is a measure of the stock volatility in tandem to the market (or trend). The higher the beta, the more volatile or sensitive the stock reacts to a unit change in the market.
For example, a stock beta of 1.2 theoretically means 20% more volatile than the market. If the FBMKLCI index (market) increases by one point, a stock that have a beta of 1.2 will increase by 1.2 in price.
Taking that into account, it makes contrarian investing harder as it is difficult to get a reliable measure of how much or the degree a stock will move against or with the trend.
Like any other investment strategy, contrarian investing pays off only if you know how to play your cards right. Having said that, contrarian investing is still a sound alternative approach on how we can invest in the stock market — if you are armed with adequate knowledge and well-versed in the market you are investing in.