“Whenever you find yourself on the side of the majority, it’s time to pause and reflect.”
– Mark Twain
Following the crowd, according to contrarian investors, leads to losses and missed opportunities. When the public responds to news or rumours about a stock or market, the price will rise or fall to the point that the company’s or market’s value has been mispriced.
A corporation, for example, could be forced to recall a product due to a design or manufacturing flaw. The recall instils widespread mistrust in the firm, sending the stock price to new lows. The problem persists, even though the stock’s perceived value is wrong. These conditions are seen as opportunities by contrarian investors. The price recovers once the sale is made and the business takes the required steps to fix the issue. Many who purchased when the issues were at their worst profited more than the average.
Similarly, common optimism often leads to exorbitant valuations that are not supported by fundamentals. The market finally understands the problem, and the price declines. Contrarian investors tend to stay away from these overly-hyped stocks because the chance of a decline is greater than the reward of a rise.
Contrarian Investors Follow the Smart Money
The contrarian investor aspires to be a member of the “smart money,” a select group of investors who understand that crowd activity is often incorrect. When intelligent money players notice a circumstance like this, they try to profit from the crowd’s intense sentiment. Bad news often exaggerates a company’s risk and prospects. In order to stop buying the company’s shares, many investors would sell these shares in a panic. Contrarian investors find distressed stocks and purchase them, then sell them when the company recovers, resulting in market-beating returns.
Similarly, overconfident investors can push up the price of a stock or the economy to levels that are not economically acceptable. These ambitious hopes inevitably come to naught, and the price plummets. Contrarian investors are suspicious of exaggerated circumstances and take care to exit or stop them. Contrarian investors prepare to go the other way to escape the losses that the masses suffer by going against the crowd, which has irrational confidence in the market’s direction.
It takes a certain amount of bravery and faith to know when to join a contrarian exchange. The dot-com bubble was in full swing in 1999 and early 2000. Many investors agree that the internet is altering the market landscape. As a result, many basic and technical performance indicators were no longer relevant. Many people bought into the market along the way, raising net capital inflows to all-time highs. The NASDAQ was propelled higher by a large amount of new capital from retail or non-professional investors. There was little left to help the massively overvalued market until the inflow of new capital stopped. The stock price plummeted.
Many who understood the market’s overvaluation were willing to sell their stocks. A few sceptics weren’t convinced by the hype. Although several of them missed the build-up, they managed to avoid the crash. Others retained their trading discipline while maintaining their downside defence. After enjoying the fantastic run-up, they were able to exit their positions as the market turned against them.
Barron’s released an article titled “Back in the Pool” on April 28, 2008. They polled a group of experienced investors to get a sense of how they felt about the market. The market was in the midst of a rally that started in 2003 and was approaching what some felt were overheated conditions at the time. The survey’s findings are as follows:
1) Describe your investment outlook through December 2008:
• Very Bullish: 7%
• Bullish: 43%
• Neutral: 38%
• Bearish: 12%
• Very Bearish: 0%
2) Is the U.S. stock market overvalued, undervalued, or fairly valued at current levels?
• Overvalued: 10%
• Undervalued: 55%
• Fairly valued: 35%
In essence, there was a heavy crowd mindset, as the overwhelming majority of people were optimistic about the industry. The S&P 500 had dropped from a peak of 1400 to a low of 735 by the end of 2008. Those who remained for a long time saw their portfolios plummet by more than 40%.
How to Be a Contrarian
Contrarian investment isn’t really about going against the grain. Instead, they seek out instances in which the economy, a business, or stock is substantially undervalued. They retain their trading discipline along the way, putting downside security in place in case the market changes course.
Contrarians understand that they cannot battle the new trend. They participate as the demand moves from the lower left to the upper right. If they see signs that the trend is coming to an end, they apply more downside cover to their portfolios, including shrinking their long positions.
They look for a new pattern to emulate until the trend has turned and their trailing stops and defensive puts have done their job. This may be the start of a downward trend. Rather than fighting the trend, they welcome it.
When a business, industry, or stock becomes substantially overvalued or undervalued, contrarian investors look for opportunities. These circumstances provide excellent entry or exit points for capturing additional profits. When a new opportunity arises, contrarian investors conduct a detailed analysis before making a decision. When people allow their feelings to take precedence over reasoning and analysis, mispriced opportunities emerge.
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