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Contrarian investing is aninvestment strategy that is characterized by purchasing and selling in contrast to the prevailing sentiment of the time.[1]
A contrarian believes that certaincrowd behavior among investors can lead to exploitable mispricings insecurities markets. For example, widespreadpessimism about astock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespreadoptimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations do not pan out. Avoiding investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any otherasset class.
Some contrarians have a permanentbear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overallstock market, nor do they have to believe that it is always overvalued, or that theconventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more "buy" candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.
Contrarian investing is related tovalue investing in that the contrarian is also looking for mispriced investments and buying those that appear to be undervalued by the market. In "The Art of Contrary Thinking" (1954) by Humphrey B. Neill; considered influential by some in contrarian thinking, he notes it is easy to find something to go contrary to, but difficult to discover when everybody believes it.[2] He concludes "when everybody thinks alike, everybody is likely to be wrong." Some well-known value investors such asJohn Neff have questioned whether there is a such thing as a "contrarian", seeing it as essentially synonymous with value investing. One possible distinction is that a value stock, in finance theory, can be identified by financial metrics such as thebook value orP/E ratio. A contrarian investor may look at those metrics, but is also interested in measures of "sentiment" regarding the stock among other investors, such assell-side analyst coverage and earnings forecasts,trading volume, and media commentary about the company and its business prospects.
In the example of a stock that has dropped because of excessive pessimism, one can see similarities to the "margin of safety" that value investorBenjamin Graham sought when purchasing stocks—essentially, being able to buy shares at a discount to theirintrinsic value with an additional margin to adjust for possible errors in one's calculations. Arguably, that margin of safety is more likely to exist when a stock has fallen a great deal, and that type of drop is usually accompanied by negative news and general pessimism.
EconomistJohn Maynard Keynes was an early contrarian investor when he managed the endowment forKing's College, Cambridge, from the 1920s to 1940s. While mostuniversity endowments of the time invested almost exclusively in land andfixed income assets, Keynes was perhaps the first institutional investor to invest heavily in common stocks and international stocks. On average, Keynes's investments out-performed the U.K. market by more than 6% with a strategy similar to, but developed independently of, thevalue investing paradigm ofBenjamin Graham andCharles Dodd.[14][15]
Commonly used contrarian indicators for investor sentiment arevolatility indexes (informally also referred to as "fear indexes"), likeVIX, which by tracking the prices offinancial options gives a numeric measure of how pessimistic or optimistic market actors at large are. A low number in this index indicates a prevailing optimistic or confident investor outlook for the future, while a high number indicates a pessimistic outlook. By comparing the VIX to the majorstock indexes over longer periods of time, it is thought that peaks in this index might present good buying opportunities.[citation needed]
Another example of a simple contrarian strategy isDogs of the Dow. When purchasing the stocks in theDow Jones Industrial Average that have the highest relativedividend yield, an investor is often buying many of the "distressed" companies among those 30 stocks. These "Dogs" have high yields not because dividends were raised, but rather because their share prices fell. The company is experiencing difficulties, or simply is at a low point in theirbusiness cycle. By repeatedly buying such stocks, and selling them when they no longer meet the criteria, the "Dogs" investor is systematically buying the least-loved of the Dow 30, and selling them when they become loved again eventually.
When thedot-com bubble started to deflate, an investor would have profited by avoiding the technology stocks that were the subject of most investors' attention. Asset classes such as value stocks andreal estate investment trusts were largely ignored by the financial press at the time, despite their historically low valuations, and many mutual funds in those categories lost assets. These investments experienced strong gains amidst the large drops in the overall US stock market when the bubble unwound.
TheFidelity Contrafund was founded in 1967 "to take a contrarian view, investing in out-of-favor stocks or sectors",[16] but over time has abandoned this strategy to become alarge capgrowth fund.
Contrarians are attempting to exploit some of the principles ofbehavioral finance, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors, regarding the long-term prospects for the company. Furthermore, Foye and Mramor (2016) find that country-specific factors have a strong influence on measures of value (such as the book-to-market ratio). This leads them to conclude that the reasons why value stocks outperform are both country-specific and behavioral.[17]
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