Contrarian Strategy

From Financial Literacy Wiki

Contrarian strategy have become a popular investment style with some fund managers during the early 2000s. While the exact investment approach adopted by these fund managers may differ, they share similar beliefs about the behavior of the stock market and that is, they believe that the stocks will revert to their mean returns because investors tend to overreact to news. Good news causes investors to chase stocks thereby pushing up the price of stocks, above their fair value and vice versa for bad news. Fads may also cause investors to over-react. For instance, stocks in 'hot' industry will attract more attention (which can increase the liquidity) while the unglamorous stocks become neglected. Herding mentality also explain over-reactions in stock markets.

Given the difficulty in determining what the true value of stocks is, investors may be tempted to invest according to how others are investing. For instance, fund managers may continue to invest in an overvalued stock because he has perfect justification that everyone else is buying it, instead of adopting the contrarian strategy which is to invest in out-of-favor stocks.

This fad or herd instinct can drive stocks above their intrinsic value for a long period time. By going against the trend, contrarian investors hope to profit when the times come that investors realise that they had overpaid for glamorous stocks and oversold on out-of favor stocks.

Pitfalls

What are the pitfalls?

First, contrarian strategy work only if reversal in stock returns are due to over-reaction by investors. Problem here is that reversals can also be explained by changes in investors' risk appetite. Consider this, suppose investors become more risk averse because of uncertainty in political or economics issues. During such times, investors will avoid the stock market unless stocks are sufficiently low. As bad news subsides, stock prices will consequently rise, thus realising the returns required by risk averse investors.

If changing risk premium is the true cause of mean reversion, then the profits that you earn by buying when the market was low and selling when the market recovers is simply a reward for the risk you bear. Unfortunately, in practice, it is hard to be sure if mean reversion is due to changing risk premiums or fads.

There are also pitfalls with "buying losers, sell winners" strategy. The reason is because there maybe rational reasons why the stock prices of losers have fallen sharply. For instance, it might be due to the firm having fallen on hard times, thus increasing its risk of going bankrupt. Further to this, when the firm shrinks in size, they may be considered too small to be of interest to investment analysts or institutional investors and therefore, their coverage would drop. This drop in research or coverage by brokers will make the company's stock less liquid.

Therefore, while a contrarian strategy may be profitable, investors should take note of the risk involved and do careful analysis.