Understanding Contrarian Investing

Confusion abounds about what contrary thinking is. Any mother would consider it an insult were someone to suggest that her baby was contrary. What mother wants to have a contrary child? In the investment world, the word generally has more complimentary connotations, though there is still little clarity on what it precisely means.

Many think that contrary means always going against the majority that a contrarian investor is automatically acting in counterpoint to the current market trend. In a long bull market, this implies being like Cassandra, who made doleful predictions that were met with scorn, and while ultimately proved right, was never believed at the time. Similarly, on this view, contrarians bet against the common wisdom in the hope of making a killing.

Another angle contrasts the contrarian with the fundamental or value investor, who buys and sells on the basis of assets' prices relative to their intrinsic value (see Value Investing). Instead, a contrarian trading strategy is based on the assumption of negative serial correlation of prices: a predictable pattern such that if prices have gone up, they must come down, and vice versa. This view of contrarians focuses on the important role of fads: rather than acting independently, investors exhibit herd-like behavior, following waves of mass optimism and pessimism

To a third group, contrarian investing is the reverse, a steadfast adherence to value- or asset-based investing. David Dreman, for example, who has written two widely read books on contrarian investing, writes a regular column for Forbes and manages a successful investment firm, describes it as "buying stocks that are out of favor according to some well-defined, fundamental measures such as low price-to-earnings (p/e) ratio, low price-to-book, or high dividend yield."Dreman is attracted to stocks that have declined in price on the assumption that a price return to something like the mean will give him a profit. He uses traditional ratio analysis of yield, p/e and book to screen his list. This is more the strategy of a traditional value investor than a contrarian, though in some sense, Dreman is still being a contrarian to the nifty fifty growth stock era of his apprenticeship in investments

In reality, contrarian investing is none of these: though the tactics of a contrarian may resemble one or more of these naive descriptions, they miss the point and seriously so. Contrary thinking is most like intellectual independence with a healthy dash of agnosticism about consensus views. While it is true that if a consensus grows to be a herd or crowd, the contrarian will flee. But not necessarily to the exact opposite. Instead, identification of a herd charges the contrarian to be more rigorous in independent thinking. And the contrarian is more likely to be attracted to a point of view that has not yet been thought of the empty file drawer idea than one that has been considered and rejected.

Contrary ideas usually guide broad strategies rather than specific investments. For example, in the late 1990s and early 2000s, Russia might be seen as providing excellent contrary opportunities in the aftermath of its 1998 debt default and currency devaluation and the subsequent flight of capital.

Timing is not usually indicated by a contrary approach. And because true contrary ideas are not an automatic knee-jerk reaction away from the consensus, there can be a number of different, good, contrary reactions to the same challenge. All may be appropriately contrary.