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Contrarian Investing – Swimming against the Stream

11 July 2008 - Features - Editor

Contrarian investing, also sometimes referred to as contrarian-value investing, involves investing in a manner contrary to conventional wisdom, where upon examination collective majority opinion appears to be incorrect. Acting on the belief that at times pessimistic crowd psychology among investors can lead to incorrect pricing of stocks due to investor opinion overstating the company’s risks and understating its future prospects, the contrarian investor cashes in on stocks that have been driven below their true value. Identifying and purchasing falsely devalued stocks and selling them once the company recovers often leads to above-average earnings for the contrarian investor.

In general, contrarian investors have a bear market outlook, and watch out for opportunities to buy or sell specific investments at a time when the majority of investors seem to be doing the opposite. A contrarian investor avoids the situation where widespread optimism causes overly high valuations on stocks, which will eventually fall to more realistic levels. The general principles of contrarian investing can be applied to any investment, whether it is an individual stock, a stock market industry sector, or any other asset class.

Some value investing specialists argue that there is no such thing as contrarian investing, because both value investing and contrarian investing are based on searching out undervalued investments. However, a contrarian investor goes beyond value investing, which relies primarily on book values and price-to-earnings (P/E) ratios, and takes into account other investors’ opinions or sentiments with regard to the stock. A contrarian may also examine sell-side analyst coverage, trading volumes, earnings forecasts, and even media releases with regard to the company’s current financial status and its future prospects.

There are a number of tools of the trade that contrarian investors may make use of in their investment decision making process. Volatility indexes such as VIX, which is also referred to as a Fear Index, tracks the prices of financial options and gives a numeric measure to the optimism and pessimism in the market. A high number is an indication of a pessimistic outlook, while a low number indicates a confident optimistic investor outlook. A comparison of VIX and major stock indexes over a reasonable period of time provides a good indication of buying opportunities.

Noted investor, David Dreman, has written several books clarifying and promoting contrarian investing, which he himself implements successfully. He also writes a regular column in the renowned Forbes magazine and is on the Board of Editors of the Institute of Behavioral Finance.

 


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