Last week’s article discussed the global stock market trends for 2018 and introduced contrarian investing as a suitable approach towards maximizing returns. Thus, this article will unfold the basic philosophy of contrarian investing.
Contrarian investing is based on the principle of ‘rationality’. To be a rational investor in the stock market, there is a need to be realistic about both the upside and downside to any investment.
An investor must first recognize the tendency to be both overoptimistic and overconfident in his or her investment decisions. An investor must also recognize the tendency to over-rely on so-called ‘experts’ for investment decision-making.
The contrarian methodology is rational because it attempts to determine if an individual company, industry or even an entire market is overpriced (irrational exuberance) or underpriced. A contrarian remembers that there were large periods of time in history in which the investors received little or no return for being invested in the stock market.
The methodology is based on one simple principle: people overreact. This tendency to overreact can be seen daily – at work, at home or even on vacation. People are highly emotional creatures – especially when it comes to love and love for money.
The same holds true for investors: investors overreact. Investors overreact to both good and bad news. There is an internal psychological pendulum in people that moves between optimism and pessimism.
Investors overprice the ‘best investments’ and underprice the ‘worst investments’.
n Investors are simply too optimistic about the stocks that appear to have good prospects.
n Investors are simply too pessimistic about those that have so-so outlooks.
Contrarian strategy execution
One of the most difficult aspects of a contrarian strategy is the strategy’s execution. As investors, we face uncertainty when we invest our capital. It represents our savings and our financial security. An investor suffers the ultimate consequence of an erosion of capital when a bad decision is made.
The success of a contrarian investing strategy requires the investor to go against the gut reactions and against the prevailing beliefs in the general market. Going against the crowd, is not easy to do. This is why most investors don’t do it. But this is also why most investors and financial managers do not beat the performance of the market index.
Most of us are influenced by societal pressures (co-workers, friends, family) that encourage the social norm. Deviant thinking from the norm is difficult because of the lack of positive reinforcement for doing so.
The reality is that a contrarian strategy takes time, discipline and patience — and most investors will give up on contrarian investing in the short run because there is optimism somewhere else in the market.
Most people are drawn towards exciting new concepts and ideas with a hope for an investment home run. This home-run approach is just not realistic as can be seen in the latest technology bubble and burst.
Still, most investors who try contrarian investing will simply not be able to stick it out for the longer term because of these optimistic and pessimistic psychological influences. However, in summary, contrarians live by the following rules:
- Concentrate on turnaround situations and stocks currently unpopular but likely to regain popularity in the medium to long-term future.
- Focus on stocks that have the ability to appreciate in value – by using the contrarian strategies.
- Analyse the management’s ability to achieve stated goals and take the appropriate action.
- Invest only in organisations that have existed for at least 10 years.
- Stay up-to-date on current events; focus on key, out-of-favour industries and shop for bargains, which allow for optimal returns.
- Normally sell 50 percent of a stock upon achievement of our rational target price, while ‘market timing’ the remainder.
- Practice patient, long-term investing, while ignoring the daily fluctuations of the market.
- Advocate strict diversification in our portfolio.
- Remain independent and sceptical of every broker, corporation or financial institution.
Defensive investing strategy
Before making a stock selection, the intelligent investor should keep two key concepts in mind. First they should question, whether they are investing or speculating with regards to a purchase that is made. Secondly they should question whether a stock selection is good value by fully understanding the concept of margin of safety – the difference in market price versus underlying value.
The single most important intellectual development of defensive investing comes from our mentor Benjamin Graham in his book entitled ‘The Intelligent Investor’. One of the most striking points made, is that over time, the general population views of what constitutes as ‘speculative’ versus an ‘investment’ has changed.
In today’s world, we are bombarded by advertisements where they heavily promote so-called ‘investing’ by using both expensive and convincing print-materials, television, radio and magazines ads. Oddly, everyone who buys or sells a security or mutual fund, regardless of the price paid or what is purchased, is considered as an ‘investor’ in today’s world. But this is not so.
How does one know? Graham identifies an investment grade equity as one that provides a safety of principal and an adequate return. Investments outside of this definition are regarded as speculative.
The major distinction between an investor and speculator is in their attitude towards stock market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations while the investor’s primary goal lies in acquiring and holding suitable securities at suitable prices.
“Psychological biases tend to interfere with sound investment decisions but investors who understand these biases can prevent them from affecting their own judgment and can profit from the biases in others.” -David Dreman