Contrarian strategies are investment methods that go against the grain, or in other words, they invest in assets that trade below their intrinsic value.
To appreciate how contrarian investing works, it is essential to understand what this means and how an asset’s current price relates to its intrinsic value.
Asset price/ intrinsic value
An asset’s price is anything from a share of stock to a bar of gold. Intrinsic value refers to the quantity of a good that would be just enough to get you through your next year if you had no income during that time.
It has been simplified for example purposes, but if we consider future expected earnings and loss, inflation, etc., all these can be used as well when considering the intrinsic value of an asset.
The idea is to come up with the asset’s value by taking into account its future earnings or cash flows, applying a sustainable discount rate and capitalizing on this value.
The distinction between price and intrinsic value is critical in understanding how contrarian investing works.
An extreme example would be Apple – say you had bought shares in Apple when it was trading at $200, then six months later there’s news that Steve Jobs has died.
Suddenly, demand for shares in Apple plummets, people sell their shares, and the share price crashes to $70. It can have occurred because most investors are emotionally driven rather than rationally driven. When Jobs died, people sold their shares without considering Apple’s future earnings and that it was still a profitable company.
This fall in share price happened because of loss aversion or “the fear of losing money”. The psychological effect here is that humans feel losses more than gains and thus aim to avoid them by selling their stocks at any given opportunity. If you had been able to sell your Apple stock when the price was $70 instead of $200, then you would have made a handsome profit.
It brings us back to why contrarian investing makes so much sense. Suppose many investors are selling an asset that turns out to be profitable.
In that case, this means there’s an opportunity for someone who can reason instead of emotionally and is willing to buy the stock at a low price and sell it high.
Contrarian uses
Contrarian investing can be used in all areas of finance such as stocks, commodities, real estate etc.
It is not limited to securities trading only; you could use contrarian strategies for buying stamps off EBAY or even antique furniture that’s been gathering dust in your attic for years.
Almost anything where people are selling because they’re emotional and panic sellers. The main principle behind contrarian investing is buying assets that everyone else has written off but could turn out to be profitable because of their intrinsic value.
Not only do contrarian investors make profits by buying these assets, but they also protect themselves from losses during downturns by having cash on hand and thus never having to sell low.
Contrarian strategies should not be mistaken for value investing strategies; while both aim to buy undervalued assets, contrarians invest in assets that everyone else has written off.
At the same time, value investors believe in buying good companies at a discount, irrespective of what people think about them.
Value investments usually involve more research and work than other investment methods. Still, the returns on these investments can be much higher if it turns out that intrinsic value is greater than the market price.
Advantages
The main advantage of contrarian investing is that you don’t need any experience or expert knowledge to get started. All you have to do is follow your emotions and look at prices from a rational point of view instead of following the herd instinct.
It could mean simply waiting for a slump in the market and buying when everyone else is selling.
Price and intrinsic value can be determined by looking at an asset’s future cash flows, sustainable discount rate and macroeconomic factors like inflation and interest rates.
The idea is to find a sustainable discount rate or expected return on investment for that asset that reflects its potential returns from here onwards.
The main idea behind using the contrarian strategy in investing is spotting market changes before anyone else. You can take advantage of these changes by buying at a low point and selling at a high point.
In that case, this contrarian strategy may be the best option for you as there would not be as much competition due to confusion over why the stock closed lower.
Remember that there are no guarantees when trading any financial instrument, but you can become a great trader using contrarian strategies with practice and informed decisions!