The word "contrarian" has a bad connotation. It implies someone who always takes an opposing stance. They like to argue just for the sake of arguing. But when it comes to investing, being a contrarian can be a very effective investment strategy. Contrary to the Wall Street herd, contrarian investors prefer to buy stocks in periods of maximum pessimism and sell stocks when investor enthusiasm drives up stock prices to astronomical levels. Thus, contrarians are perfectly comfortable unloved stocks. They're also are happy to sell stocks that become Wall Street darlings. Suffice it to say that contrarians themselves are not Wall Street darlings, because they're, well, so contrary. But if you have had some experience investing in both up and down markets, you probably have some appreciation for the wisdom of deviating from the hysteria that inevitably accompanies rising and falling investment markets.
While it's important to maintain a consistent approach to investing, it's equally important to resist the hysteria that often influences the investment markets. That's why so many investors – and investment advisors – fare so poorly over the long term. Here is an illustration of reactions of the herd vs. the contrarian to various conditions in the stock and bond markets
Reactions to Changing Markets
• Stocks are rising:
- The herd: "I've got to move more money into stocks. I don't care how much they've risen. I don't want to miss out."
- The contrarian: "Stocks are awfully expensive and everyone thinks stocks will just keep rising. I've made some good money, but I'm going to lock in those gains right now by selling some of what I own, because stocks don't rise forever."
• Stocks are falling:
- The herd: "I can't stand losing money, and it looks like there's no end to this bear market. I've got to cut way back on my stocks."
- The contrarian: "There's blood on Wall Street and the speculators are unloading stocks. Stocks are a lot cheaper now than they were a few months ago. I'm going to buy some solid but beaten down stocks."
• Bond prices are falling (which means interest rates are rising):
- The herd: "It's bad enough losing money on stocks, but now my bonds and bond funds are taking a pasting. It's time to switch out of bonds and put more into stocks."
- The contrarian: "Yes, my bonds have been through a rough patch, but that's because interest rates have risen. But I'm going to take advantage of higher interest rates by buying some more bonds."
• Bond prices are rising (which means interest rates are falling):
- The herd: "Bonds have been making money recently, and I want to be where the action is, so I'm buying bonds."
- The contrarian: "I've been getting some gains in my bond holdings, but with interest rates falling, this is hardly a time to be buying more bonds. If anything, I'll lighten up a bit.
Becoming a moderate contrarian. Some professional investors are died in the wool contrarians. They are perfectly happy to be out of stocks when everyone else is euphoric about stock market prospects as they are to plunge into stocks amidst a plunging stock market. But that's too dangerous a strategy, because no one can reliably predict the future of the stock or bond markets. The last thing you want to do is make major shifts in the way you invest, whether you follow the herd or are a contrarian. But by taking a contrarian approach to the way you invest will empower you to make smart investment decisions that are not in sync with what everyone else seems to be espousing. Further, you can be a contrarian without deviating from your investment diversification target. Here are two ways to be a moderate contrarian: