If there’s one thing investors love, it’s being right about a stock that everyone else was wrong about.
To be fair, there is a certain satisfaction in making a higher-than-average profit in a stock that no one else looked at twice, or even outright dismissed altogether. But as with most things, great rewards come with great risks. Being a contrarian can mean adding a new level of volatility into your overall investment strategy.
In order to be successful, investors need to understand what a contrarian strategy is and how it can benefit their portfolio.
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The Ins and Outs of Being a Contrarian
A contrarian strategy is defined as being one that runs contrary to the generally accepted consensus on a stock. If most investors believe a stock will outperform the markets, but you believe that it will actually underperform or even fall in price, you are a contrarian. It can even be as simple as buying a stock that no one is paying attention to. In other words, contrarians go against what conventional wisdom says to do.
Some of the most successful investors have contrarian strategies that they employ. Warren Buffett is well known for buying stocks when everyone else is selling them – by doing so, he often picks up valuable companies at deeply discounted prices.
A contrarian doesn’t have to be someone with a large appetite for risk either. Value investors usually identify as contrarians as well because they like picking stocks that others have ignored or dismissed. Some of the most successful investors have contrarian strategies that they employ.
Oftentimes a stock that is unpopular or covered by just a few analysts, if any at all, is trading at a mispriced value. This follows along the efficient market hypothesis where stocks will trade at fair value if investors have all the available information at their disposal. If most investors thought XYZ stock would underperform markets, but you decided that based on your research, it will actually outperform the averages – that would make you a contrarian.
Finally, contrarians need to have an awareness of macroeconomic elements taking place in the markets. A working knowledge of how the business cycle works and what sectors tend to outperform or underperform during each stage will help you to select promising companies at discounted prices.
A Walkthrough of a Contrarian Trade
As noted previously, to be a contrarian, one simply needs to act differently than the majority of investors. This can manifest as being bullish on a stock no one believes in or being bearish on one that everyone else says will head higher.
Let’s walk through an example of how a contrarian strategy can play out for investors.
Right now, commodity prices and commodity-driven stocks are performing rather well. Technology is almost always a popular sector for investors too. But one sector that no one is paying much attention to is apparel retailers. A stock like Urban Outfitters (URBN) could be a potential buy for contrarians because it’s a stock that is down 20% in the past quarter and hasn’t received any positive coverage by Wall Street experts.
The key difference between successful contrarians and unsuccessful ones is knowledge. Knowing how to apply fundamental analysis is arguably the most important trait for contrarian investors. And once you know what to look for in a stock, you don’t have to rely on the experts to tell you if a stock should be bought or sold.
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Potential Risks for Contrarian Trades
The biggest risk to the contrarian strategy is simply being wrong. In many cases, the majority of investors are correct about the future performance of a stock, so going against the crowd can be a risky endeavor.
Short sellers usually run the highest risk as contrarians. That’s because shorting a stock – selling it now and buying it back later, ideally at a lower price – has no limit as far as how high a stock’s price can reach. While bullish investors could theoretically lose 100 percent of their investment if the stock falls to zero, short sellers can lose in excess of 100 percent.
To mitigate these risks, you’ll need to maintain a high level of diligence in your investment strategy. That means that you will need to spend some extra time analyzing a stock that you selected as a contrarian trade. Understanding how to read financial statements, such as the company’s annual 10k, and using financial ratios to assess a stock’s true intrinsic value are critical skills for any contrarian.
Introducing risk mitigating tools such as option contracts in addition to stock purchases or sales is another way of staying diligent in your investment portfolio. For example, short sellers who cover their shorts with a simple call option can greatly reduce the level of risk they take on in a given trade.
Check out this article to learn more about covered call options.
If engaging in a contrarian strategy sounds like something you might be interested in trying, there are ways to safely incorporate it into your portfolio selection process.
Final Thoughts
A contrarian is really just an investor that selects a bullish or bearish position in a stock that goes against the thoughts of the majority of other investors. Applying fundamental analysis in your stock trades and understanding the macroeconomic elements of the market are key factors in being successful as a contrarian.
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