What does it mean to be a contrarian? The most common definition is a person who opposes or rejects popular opinion and goes against the current practice. So, if you're a male and you don't have a beard, skinny jeans or a plaid shirt and your hair isn't shaved on the sides, you just might be a contrarian.
On a more serious note what does it mean to be a contrarian investor? A contrarian investment style is one that buys or sells in contrast to the prevailing sentiment of the time. A contrarian believes that the crowd will eventually be wrong or that the predominant crowd behavior among investors will lead to exploitable mispricings in securities. In short, it means investing against the crowd.
Sounds pretty simple doesn't it? Just buy what the majority of investors don't like such as beaten up, unloved stocks or that unpopular commodity that's down 50%. Or simply short that market that has gone parabolic and can't possibly go any higher. This sounds good in theory but in the real world with real money it's not that simple.
Being a contrarian investor is like being an early pioneer of undiscovered continents. You may be the first to explore new territory but you might end up with a couple arrows in your back.
Going against the crowd or prevailing trend can be extremely painful. This is because it's impossible to know how long it will take the bear or bull market to run its course. You may eventually be proven right but do you have the patience, confidence and the risk management skills needed to eventually succeed? Precious investment dollars can get tied up in a market that could potentially go against you or move sideways for months or even years.
The market can make fools of those who think they can sell the exact top or buy the bottom tick. The market is very good at doing the most obvious thing but in the most confusing way possible. This confusion is volatility, which creates frustration for the short term market players whipsawing them out of their positions and blowing up accounts along the way.
A good way to manage risk while waiting for the next big trend to form is to take a smaller position, with the plan to add to it once the market moves in your favor. Another tactic is once you establish a position, be quick to exit with a small manageable loss if price move against you. This way you won't tie up capital for too long or suffer a devastating loss by hanging on while the market makes new lows. You can always re-enter the market once you decide the bottom is in.
How do we know when a market has bottomed? One way is to wait for that beaten up and hated market to start to show signs of life by displaying positive price action indicative of an uptrend. A good way to define a uptrend is a series of higher highs and higher lows on a price chart. A longer term price chart will eliminate some of the noise and provide a better perspective.
Take a look at the US equities markets represented by SPY (SPDR S&P 500 ETF) in the weekly chart below. By ignoring the noise (news and conflicting analyst reports) and by only following the rule of higher highs (HH) and higher lows (HL) you would still be riding this trend today which is up over 85 percent!
Contrarian investing can yield tremendous gains but it often takes longer than you think for a bottom to form and other investors to join the party. But once a legitimate trend takes hold,
investment capital will find its way into that market potentially driving it higher then anyone expects.
Contrarian investing takes courage. The courage to enter a hated, forgotten about and unpopular market. However, this courage should not be blind to the risks that are constantly present. Therefore the need to follow a detailed plan is essential in order to take advantage of these rare opportunities.