What Is a Contrarian? Strategy in Trading, Risks, and Rewards (2024)

What Is a Contrarian?

Contrarian investing is an investment stylein which investors purposefully go against prevailing market trends by selling when others are buying and buying when most investors are selling. Berkshire Hathaway Chair and Chief Executive Officer (CEO) Warren Buffett is a famous contrarian investor.

Contrarian investors believe that people who say the market is going up do so only when they are fully invested and have no further purchasing power. At this point, the market is at a peak. So, when people predict a downturn, they have already sold out, and the market can only go up at this point.

Understanding Contrarian Strategy

Contrarian investing is, as the name implies,a strategy that involves going against the grain of investor sentiment at a given time. The principles behind contrarian investing can be applied to individual stocks, an industry as a whole, or even entire markets.

A contrarian investor enters the market when others are feeling negative about it. The contrarian believes the valueof the market or stock isbelow its intrinsic value and thus represents an opportunity. In essence, anabundance ofpessimism among other investors has pushed the price of the stock below what it should be, and the contrarian investor will buy that before the broader sentiment returns and the share prices rebound.

According to David Dreman, contrarian investor and author of Contrarian Investment Strategies: The Next Generation, investors overreact to news developments and overprice "hot" stocks and underestimate the earnings of distressed stocks. This overreaction results in limited upward price movement and steep falls for stocks that are "hot" and leaves room for the contrarian investor to choose underpriced stocks.

Special Considerations

Contrarian investors often target distressed stocks and then sell them once the share price has recovered and other investors begin targeting the company as well. Contrarian investing is built around the idea that the herd instinctthat can take control of market direction doesn't make for a good investing strategy.

However, this sentiment can lead to missing out on gains if broad bullish sentiment in the markets proves true, leading to market gains even as contrarians have already sold their positions. Similarly, an undervalued stock targeted by contrarians as an investment opportunity may remain undervalued if the market sentiment remains bearish.

Contrarian Investing vs. Value Investing

Contrarian investing is similar to value investing because both value and contrarian investors look for stocks whose share price is lower than the intrinsic value of the company.Value investors generally believe that the market overreacts to good and bad news, so they believe that stock price movements in the short term don’t correspond to a company'slong-term fundamentals.

Many value investors hold that there is a fine line between value investing and contrarian investing, since both strategies look for undervalued securities to turn a profit based on their reading of the current market sentiment.

Examples of Contrarian Investors

The most prominent example of a contrarian investor is Warren Buffett. "Be fearful when others are greedy, and greedy when others are fearful" is one of his most famous quotes and sums up his approach to contrarian investing.

At the height of the 2008 financial crisis, when markets were tumbling amidst a wave of bankruptcy filings, Buffett counseled investors to buy American stocks. As an example, he purchased equities for American companies, including investment bank Goldman Sachs Group, Inc. (GS). Ten years later, his advice proved to be correct. From 2008 to 2018, Goldman's stock had jumped by approximately 239%.

Michael Burry, a California-based neurologist-turned-hedge fund owner, is another example of a contrarian investor. Through his research in 2005, Burry determined that the subprime market was mispriced and overheated. His hedge fund Scion Capital shorted the riskiest parts of the subprime mortgage market and profited from them. His story was written up into a book, The Big Short, by Michael Lewis and has been made into a movie of the same name.

Limitations of Contrarian Investing

Investors interested in employing a contrarian investing strategy should be aware of some of the strategy's drawbacks. It can be challenging to find undervalued stocks and contrarians typically spend a great deal of time researching stocks and various industries to find potential investment opportunities. It will not be enough to rely on simply doing the opposite of the prevailing market sentiment. It's important for contrarians to develop their skills in fundamental analysis to accurately measure a security's intrinsic value.

Contrarians may have periods where their portfolios underperform. It may take a significant amount of time before an undervalued stock begins to show gains. In the meantime, the contrarian investor may have to endure paper losses on their investments.