Contrarian investing: what it is and how to get started

The contrarian investor goes against the herd. Contrarians have the knack of knowing that when the market is bullish, a crash could potentially happen, and when an asset is universally disliked, that’s when it usually rallies. Why? Because when everyone who is likely to buy already owns the asset, there is no one left to keep the price up. And with no buyers at high prices, those who are selling are forced to sell at lower prices – therefore, dropping the price.

Contrarians see this scenario playing out in various asset classes as well as individual stocks. They try to buy on the cheap when the market doesn’t like something and sell when the asset comes back into favour, and people are buying and pushing the price up.

To a certain extent, anyone can be a contrarian. All it takes is the ability to successfully notice when a stock is being pushed way higher or sold off way more than is justified. Experienced investors will often keep an eye out for these sorts of things.

However, investors who are perpetual contrarians, and make contrarian investing their primary strategy, often like to do things differently. They aren’t comfortable with the status quo, like pushing their limits and are comfortable being uncomfortable. They are OK with being criticised for their views (or they don’t express them) because most people who are part of the majority will be on the other side of the trade. They are not afraid to take continued small losses as a market grinds higher if they think there will eventually be a large short and sharp decline that will make them an overall profit.

Contrarians like good deals, which most often occur in the financial markets after a price decline, and they typically see big price rises as a chance to exit.

In terms of execution, a contrarian investment approach is no more difficult than any other strategy. For investors who are natural contrarians in other areas of their life, this style of investing may come more easily than a trend-following strategy, for example. But for someone who is not a contrarian by nature, this style of investment strategy​ will likely be uncomfortable.

A lot of investors will be in constant disagreement with a contrarian’s opinion or investments. Also, sentiment doesn’t always turn quickly. It may take weeks, months, or years for an investment to move as expected. Therefore, strong risk-management and time management of trades are essential. Otherwise, a contrarian may end up holding an asset that keeps losing them money or ties up their money while waiting for a move that never comes.

Contrarian investing can overlap with value investing. When a stock price falls but the fundamentals of a company are still sound, that may present a buying opportunity.

Price to earnings ratio (P/E) is one valuation method used to assess this. The P/E ratio is calculated by dividing the earnings per share figure by the market price of the shares. For example, if a stock often trades at a P/E of 20–30 but can be purchased at a P/E of 10 at a certain time, that may appeal to a value or contrarian investor if they have identified that the stock is trading below or around its intrinsic value. Similarly, if a contrarian owns this stock and it moves up to a P/E of 40, it may be time to sell, since the stock is more richly valued than normal.

Market sentiment is how bullish or bearish people’s opinions or positions are. When sentiment is extremely bearish, the contrarian is looking for buying opportunities. When sentiment is extremely bullish, the contrarian is selling. Sentiment can be used for short or long-term trades.

Market sentiment is gauged by sentiment indicators. Some traders develop their own indicators, while others use publicly available ones, such as the CBOE Volatility Index.

These indicators are based on behavioural finance, a field of study that looks at how emotions affect financial decisions. When in fear, people sell, often without regard for logic or intrinsic value. Those who remain steady and logical can then potentially capitalise and scoop up some deals.

Contrarians may also use a mean-reversion strategy. For example, as the stock market rises over time, they want to buy on pullbacks below the long-term average trend and sell when prices are above the long-term average trend. A moving average can reflect the long-term average price.

This approach can be used with price itself or with fundamental statistics such as P/E or book value. The contrarian buys when these statistics are attractive relative to the long-term norm and sell when the statistics are expensive compared with the long-term norm.

Market selloffs are typically associated with high volatility – large and fast drops in price. Quite often, market rallies are marked by low volatility and small, steady price rises.

Contrarian investors expect these conditions to reverse. High volatility is typically followed by low volatility and higher prices. Very low volatility is often followed by high volatility and lower prices (although low volatility can last for weeks or even many months).

Michael Burry, made famous by the movie The Big Short, bet against the housing market when demand for properties was soaring. People thought his bets against the housing market were unjustified – even his own investors and business partners. Ultimately, his bet proved correct, netting a profit of over $800m as stocks and housing entered a bear market.

Warren Buffett is also considered a contrarian as he is a value investor. He tends to buy stocks when they are plunging and trading below their intrinsic value. During the financial crisis in 2008, Buffett bought $5bn worth of preferred shares in Goldman Sachs while the common stock was being heavily sold off, according to The Week magazine. In 2011, Goldman Sachs bought back the stock for $5.64bn and handed Buffett a $500m bonus. Learn more about Warren Buffet's investment strategies​.

Another famous contrarian investor is Bill Ackman, who is known for taking short (betting against) positions in popular companies. This is usually because he believes the company is overhyped or trading too high above its intrinsic value. Similarly, he will buy companies that are unloved in anticipation that they will turn around or sentiment will once again favour these companies. However, to show that the pros don’t always get it right, Ackman shorted the nutritional supplement maker Herbalife, calling it a pyramid scheme. He lost approximately $760m on the trade, according to StreetFins.

George Soros is another contrarian investor. On Black Wednesday, on 16 September 1992, Soros bet against the British pound and made more than a $1bn profit in a day. He is known as “the man who broke the Bank of England”. He did not believe the status quo would prevail and helped force the British pound down to a price he thought was more reflective of its true value. The pound continued to sell off into early 1993.

Here are some succinct quotes that represent the true nature of contrarian investing.