“That’s me!”, you say. “I’m different – I have my own thoughts.”
If you are reading this, you are most likely not a contrarian. How do I know? I know because in order for contrarianism to work, you have to go against the majority. For this to be the case, there has to be a dominant group and chances are you’re part of it. Don’t be offended; it’s a statistical fact.
The problem with attempting to be a contrarian is that it goes against our very psychology. As children, we are all raised with conventions and behaviors that will allow us to function as members of a group. Our families rewarded acceptable behavior and punished unacceptable behavior. Investors are not immune; they too, are susceptible to “groupthink”. Because of the overwhelming need to conform, “groupthink” causes members of a group perceive things the same way. On Wall Street, this makes it very likely that investors will think similarly.
Contrarians want to exploit “groupthink”. The theory is that contrarians can profit by doing the opposite of the majority traders. If the general market is bullish, most participants are already going long so the path of least resistance is down.
As an example, if everyone believes that Facebook stock will increase and they believe in it strongly enough to purchase the stock, a contrarian investor can profit from taking the opposite position. If everyone has already purchased Facebook stock, who is left to push it higher? The path of least resistance is down.
Many people believe that they are contrarians because they disagree with market sentiment. That’s good and well, but to be a true contrarian, you must make a decision to act. However, acting on generalities is not enough – you must search out and act on extremes.
Continuing with the Facebook example, let’s say Facebook stock plummets from $74 to $15 and people are predicting it will fall even more. In fact, you can’t seem to find any fund or individual investor that will touch Facebook stock. That’s an extreme! Provided the fundamentals of the company are still good, you should act and buy. If there’s no one left to sell his or her shares, what’s the path of least resistance? Up.
Be aware that you can make a mistake in your timing, as it is impossible to time the market. You may purchase Facebook stock at $15 only to watch it fall to $10 – this is a risk in any investment, but as a contrarian, you don’t get caught in the mania. You avoid the devastating drop in the first place.
It’s important to have certain proxies that will allow you gauge market sentiment. This can be a big percentage drop, a very low P/E, a low P/S, a low P/B or something else that you choose. The idea is to use a guideline to measure extreme opinion held by investors. Crowds have a tendency to latch on to a particular stock and push it to an extreme. Your advantage as a contrarian will be to avoid the super-hyped, glamorous stocks that are pushed to extreme. These over-extended investments are ripe for a fall.
Please understand that being a contrarian is a loner’s game. If you go to a party and talk about how you’re buying up $15 Facebook stock, you’ll soon find that you’re talking to yourself. People fear taking a solitary stand on a stock and act on majority opinion for comfort. They’re going along for the ride because all their friends are making money. Why shouldn’t they get their piece? Sooner or later there will be too few people to push the price higher.
It’s a sobering fall from the top.