When investing in the stock market, most traders tend to focus on and adopt strategies that are tuned towards following the existing trend in the market. While they do enable investors to reap handsome gains from trades, they are not the only strategies available. In fact, contrarian investing strategies are quite popular with a large segment of traders. Wondering what contrarian investing is? Here’s everything that you need to know about this unique style of trading.
What is contrarian investing?
Technically, any strategy that an investor adopts to go against the prevailing market trend is termed as contrarian investing. For instance, if the market is on a downtrend and a trader initiates a long position instead of going short on a stock, such an approach is what financial and stock market experts term as a contrarian strategy.
Now that you’re acquainted with this peculiar method of investment, let’s try to understand the logic behind why traders prefer to adopt contrarian investment strategies instead of just going with the flow.
Why do some investors prefer contrarian investing?
Before we delve into the logic behind such behavior, let’s take a quick look at how the stock market generally tends to behave.
Contrary to popular opinion, in the short-term, the primary driving force behind the movement of the stock prices is the sentiment of the investors and other market participants. If the market sentiment for a stock is positive, the stock is likely to witness a rise in its price. However, if the market views a stock negatively, the price is likely to slide down due to the selling pressure.
And when it comes to the long-term, the main driving force behind the movement of the stock prices is the fundamentals of the company. If a company is fundamentally strong, then the likelihood of its stock appreciating in value in the long-term is high. On a similar note, if the fundamentals are weak, the stock would languish.
We know by now that the stock market can be quite unpredictable. Even then, occasionally, the market participants tend to make irrational investment choices in a fit of panic. For instance, when the COVID-19 pandemic hit the world, investors went on a huge selling spree and drove down the prices of almost all of the stocks. Even the fundamentally strong ones were not spared. Pessimistic sentiments were on a high and many concluded that it was a bad time to enter the market.
However, here’s where contrarian investment strategies come in. Under such situations where the popular opinion is to stay away from the market, investors who prefer contrarian investing look out for opportunities to enter. Their logic is to pick up fundamentally strong companies with huge future growth potential that have been beaten down due to overwhelming negative sentiments. They invest in such companies at bargain prices and hold onto them till the market sentiment turns positive and the prices pick up. Once that happens, the contrarian investors sell off their holdings and enjoy multi-fold returns on their investments.
The returns that these investors get to enjoy by adopting a contrarian strategy may be much larger than what they would generally get if they followed the trend. This is one of the primary reasons why many traders and investors prefer a contrarian investing approach.
What are some things that you should keep in mind when adopting a contrarian strategy?
If you’re planning on going the contrarian way, here are some key things that you should always keep in mind.
1. Go against the trend: Try not to blindly follow a group of investors. Instead, develop an independent thinking process and ensure that you do your own research.
2. Take advantage of negative market sentiments: Disasters, whether natural or man-made, are great opportunities to buy fundamentally strong stocks at rock-bottom prices.
3. Think long-term: When adopting a contrarian strategy, it is highly essential to have a long-term view since it may take quite a while for the beaten down stocks to bounce back up to fair value.
4. Always stay alert: Keep yourself updated on the financial performance and fundamentals of the companies you’ve invested in. If a company that you’ve invested in shows signs of deteriorating performance, it would be a good idea to exit early to minimize the losses.
5. Stay calm and don’t panic: Timing the market is a notoriously hard thing to do. Picking up stocks when they’re at their bottom is extremely hard. It is akin to catching a falling knife. Therefore, if you witness your stock sliding further downwards after investing, it is a good idea to be patient and calm instead of panicking and letting it go.
That said, a contrarian strategy may not be everyone’s cup of tea. While it may sound all well and good on paper, it does not guarantee success. Also, the level of risk with such a strategy is much higher than what you would experience if you simply went with the flow. So, before adopting contrarian investment strategies, always make sure to thoroughly analyze the stock and the market before making an entry.