Winning against the herd: How to become a successful contrarian investor

The crowd is not wrong all the time. And the contrarian investor is not the one who expresses a stubborn dissent to market opinions all the time. In the stock market, we often hear that ‘the public is right during the trends but wrong at the ends’.

The crowd is wrong at turning points and that is the precise point where a contrarian investor tries to position himself and take advantage of the possible change in trend. The contrarian investor too wants the crowd to join him ultimately, to enable him to profit from the investment.

A contrarian investor understands and identifies the areas in the market where the crowd has overreacted, resists the temptation to go with the flow and sets up an opposite position to the trend to ultimately benefit when the market realises its mistake.

Genesis of contrarian investing

Proponents of the efficient market hypothesis believe that people behave rationally while making investment decisions:

o They incorporate any new information perfectly into the price (using Bayes theorem);

o They make optimum allocation decisions (based on calculated expected value or the efficient frontier). They also believe in the wisdom of the crowds:

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o Even if individuals may suffer some biases in their decision-making, the crowd does not. When different individuals interact in the market, their errors cancel out each other and hence the prices are close to their fundamental values.

o In case there is a net bias which is not negated, there are arbitrageurs who will come in and trade in a way that they make a riskless profit and the prices again revert to the fundamental values.

In reality, people are not very good at handling complexity and uncertainty. Individual investors are not perfectly rational in their financial decision making and do get affected by biases. As mentioned, most of the time the crowd can be right. However, the crowd is influenced by narratives, they extrapolate recent trends into the future (Recency bias) and often ignore regression to mean and base rates (cycles). This can lead to imitation within the crowd and results in herding. Herding breaks the diversity in the market and creates a market bias. A feedback loop sets in which pushes the market prices further in the direction of the bias and reinforces the trend (Reflexivity).

Behavioural economists have shown that in such conditions arbitrageurs cannot really influence the prices. The crowd ends up being positioned at one extreme side of the market (overreacting in optimism or pessimism). This is the opportunity for the contrarian investor. An opportunity to buy from the pessimists or sell to the optimists.

The challenges in the path

Life unfolds in cycles, but people project it in straight lines. In the market cycle too, booms are followed by busts, excesses sow the seeds of reversal. The contrarian investor understands and profits hugely from this behavioural cycle. Unfortunately, this path is not without obstacles.

Fundamentals and psychology

To understand if the market prices are unreasonable in either direction, the contrarian investor must have a good handle on what is the reasonable value. It is important to have grasp of the intrinsic value before claiming a security or asset is mistakenly over or undervalued. Along with the fundamental knowledge, the investor must also understand the behavioural cycle of the market. Many investors are trend followers; they may rush in to participate in a bubble. By studying both, the fundamental and the behavioural cycle of the market, the investor can position himself correctly.

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Timing is important and difficult

‘Markets can remain irrational longer than one can remain solvent’. A contrarian investor disagrees with the crowd but should know when to act on that disagreement. After establishing a position, the investor may have to wait for a long time. Market can continue to move in one direction if it is driven by a seductive narrative. The crowd may take a lot of time to finally change course. Remember, by its very construct, contrarian investing is about being early.

Standing alone is difficult

Being a contrarian investor is contrary to our natural reaction. Resisting the temptation to participate or conform to the majority, standing alone against the crowd, betting against what seems obvious, etc, is a difficult position to maintain psychologically. It takes courage and perseverance. Recently, scientists have shown that standing against the crowd impacts the same areas of the brain that get affected by physical pain.

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Get the set-up right

The strategy is right: a contrarian investor buys when the prices are low and sells when they are high; logically, there is a lot of money to be made. It sounds simple but it has its own challenges. Keeping the right set-up may help implement the contrarian strategy effectively. Some of these ideas may help:

o Have a screener to hunt for contrarian opportunities

o Make a checklist of conditions that help qualify investments

o Build positions slowly – as you can’t predict the exact top or bottom

o There is a need for patience – for you, your clients, your management and sponsors

The author is the chief investment officer of Bajaj Finserv Mutual Fund

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