Exponents of contrarianism should be less exposed to the stocks most vulnerable to profit taking or panic selling in the event of a crisis of confidence or market correction.
Just as it may provide lower downside risk, this style of investing seeks out ideas that should have greater upside relative to already successful and highly valued shares.
Crowding or ‘herd instinct’ is one of a well recorded number of biases humans are prey to. All too often irrational behaviour can dominate the markets.
Behavioural finance research highlights that investors are prone to cognitive errors and are poor intuitive statisticians, concerned with feelings and emotions, with a tendency to be backward looking and prone to satisfice in decisions rather than optimise.
Humans are imperfect decision makers – often constrained by time and access to information. These cognitive limitations lead to a reliance on assumptions or ‘rules of thumb’ to make sense of, explain, justify and control complicated situations or information.
This results in behavioural biases such as over-confidence, over-optimism, loss aversion and an inclination to select certain information as representative, to anchor or frame decisions or confirm a current stance.
The contrarian stock picker seeks to manage their own biases while at the same time take advantage of these same biases inherent in the market - the contrarian challenges the ‘wisdom of the crowd’.
Crowds tend to exaggerate reactions to information and extrapolate current trends with less care for valuation signals or the consideration of realistic cycles – this is the basis for momentum investing which ultimately relies on the ‘greater fool’ premise. Given human behaviour, the natural formation of asset bubbles is arguably inevitable.
Cycles matter
Life is dominated by cycles that present opportunities for the contrarian investor, such as capital, supply, demand or confidence and sentiment. Ideas or trends follow a cycle of popularity and the same applies to stock and market themes.
Fashionable stocks eventually become overvalued, while less popular stocks by the same token become cheap. Analysts tend to pay less attention to stocks they don’t like and these can then fall further out of favour.
Company management teams are also predisposed to swings between over-confidence and excessive pessimism – it’s important to draw one’s own conclusions about industry cycles.
Emotions follow a similar principle - the ebullience and euphoria or panic and remorse that are an ever-present part of investing are powerful motivators which can become self-sustaining, until the cycle turns.
Below are five things to consider when searching for contrarian investment opportunities:
1) Don’t follow the crowd
