Can you be a contrarian investor?

12th March 2012

One of the team at Mindful Money asked me for an opinion on contrarian investing recently.

I gave her a point of view, but it made me think.

There seem to be different definitions of what it means, for a start.

Sometimes it seems to be about always going against the prevailing sentiment, sometimes it's only when the prevailing view is seen to be wrong.

I don't want to get into the area of "basic investment is about the rise in value over time, therefore there is always long-term optimism and contrarianism is therefore compulsorily based on a bearish view".  That's getting into economics and investment theory, and I don't pretend to be expert on them.

What I want to do is set out some of the psychology that seems to rule it and, since I'm a scientist and an evidence based practitioner, discuss some of the evidence.

If we're talking about sentiment, noise, feeling in the market (which is what we seem to be doing) we're talking about fairly short term things.

That seems to mean that a contrarian is listening to the market noise and doing the opposite of what the "word on the street" says, while the mainstream follows the word on the street.

So contrarianism works on exactly the same material as the mainstream, it just does the opposite.

I can't see anything wrong with that, but it does make things a bit tricky.  You're dealing with people's beliefs, irrationality etc.  So imagine this:

There's a celebrity talent show (say like Strictly Come Dancing) where you get a prize for voting for the eventual winner. The eventual winner will be the one who gets the most public votes. You happen to think contestant A is best. You know that your friends prefer contestants B or C. Will you vote for A, knowing that they probably won't win and you won't win the prize? Vote for B or C, knowing that they are more popular and therefore more likely to win?  Or vote for, say F, because you've read that they make huge charity donations and you think that most people will like them and vote for them?

If you substitute "investor" for "public voter" and share for celebrity, that's pretty much what you've got in a market.

Whatever you do with votes, investments etc., notice that you don't care about who is the "best" any more.  You are not concerned with value, fundamentals, management teams etc. you are thinking about "who do other people think is the best", or more accurately "who are they going to vote for or invest in"? The real "value" is irrelevant, you're trying to read the mind of everybody else, work out who will win and vote accordingly.

So it seems that in order to profit by that, you have to have some sort of expert knowledge of who the best dancer (or best value share) is.

Which means you've got to ignore the gossip and sentiment altogether and work those things out.  When you've done so, you might go for a contrarian stance – but only because you think it is valuing the shares wrongly, not because somehow being contrarian is better.  You might just as easily decide that market sentiment is right about the long term value.

However, maybe it means that you can work out arbitrage opportunities.

Continue reading…


More from Mindful Money:

Contrarian Investor – Betting against the noise

Can we have transparency – or is that the wrong question?

Crowdfunding – same wine different bottle?

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