Contrarian Investing

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 dyed 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:

  1. Periodically rebalancing your investments. If you have paid close attention to how you diversify your investments and you select good investments, it's hard not to be a successful investor. But periodically rebalancing your investments is icing on the cake, because it forces you to make contrarian investment decisions while sticking to your long-term investment strategy. Rebalancing is a mild but very smart form of contrary investing. Rebalancing your investments is a way to be both a contrarian investor while sticking with your long-term investment strategy. Here's how rebalancing works. Before you can rebalance, you need to establish a diversification target for your investments, for example 60% stocks and 40% in bonds. Over time the investments you own will change in value. After one year, let's assume your allocation has changed from 60%/40% to 65% stocks and 35% bonds because the stock market rose. The task at hand is to sell enough stocks and buy a like amount of bonds to get back to the 60%/40% target allocation. Now you may ask, why is rebalancing a contrarian investment strategy? Because rebalancing forces you to buy stocks on the cheap – after they've fallen in value – at a time when the Wall Street herd is abandoning stocks. Rebalancing also forces you to sell stocks after they've risen in value as was done in our example. The other thing that rebalancing does is to force you to buy bonds after interest rates have risen which is exactly what you want to do – lock in higher interest rates. But rebalancing usually only involves small shifts in your overall investment holdings, so you're not making a major move. This is good.
  2. Identifying out-of-favor securities to invest new money. Occasionally you'll have some money that needs to be invested. A maturing CD, a gift from Granny, an IRA contribution, or you just have a small brokerage account for speculation. In these instances, you can exercise your contrarian proclivities by following your instincts rather than the herd. If everyone in the office is plowing money into stocks, buy bonds. If a stock you like has taken a drubbing lately but still has good prospects, buy that stock. It's on sale. If a couple of experts on the financial news shows predict the imminent demise of small company stocks, buy a small-cap stock fund. It's fun being a contrarian, and the odds of success are in your favor.