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Contrarian investing

Contrarian investing is the complete opposite of momentum investing. It assumes that financial instruments which have been rising steadily will reverse and start to fall, and vice versa with falling. It is the best time to pick up great stocks at good value as people are driven by irrational fear and dumping all the stocks. In fact, it's one of Warren Buffet's most well-known strategies, "be fearful when others are greedy and be greedy when others are fearful". On the other hand, if the market is extremely bullish and people are saying things like prices will keep on going higher, market valuations are reaching new heights, it is time to act cautiously and maybe sell some of your stock holdings. Even if you do not sell, you probably do not want to be buying stocks at such high valuations.

In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong. Contrarian investing is a market timing strategy used in all trading time-frames. Basically, you buy when the economy is in bad shape and words like recession, depression, no bottom for the stocks appear constantly in newspapers. The contrarian trader buys an instrument which has been falling, or short-sells a rising one, in the expectation that the trend will change.

Notable contrarian investors

  1. Warren Buffett is a famous contrarian, who believes that best time to invest in a stock is when shortsightedness of the market has beaten down the price.

  1. David Dreman is a money manager often associated with contrarian investing. He has authored several books on the topic and writes the "Contrarian" column in Forbes magazine.
  2. John Neff, who managed the Vanguard Windsor fund for many years, is also considered a contrarian, though he has described himself as a value investor (and questioned the distinction).
  3. Mark Ripple is a money manager often described as a contrarian. He has authored a book covering the topic in detail

Momentum and contrarian

When it comes to timing the stock market, there are generally 2 investment styles. One is to invest with the crowd and follow the momentum, hence named momentum investing. The other is to go against the crowd and do what everybody else is not doing, hence named contrarian investing. These 2 - momentum and contrarian strategies are polar opposites; therefore you are either a momentum investor or contrarian investor.

Momentum investing is usually used by traders who move in and out of positions regularly. The basic idea is that once the market gains momentum in either direction, it will keep on moving towards that direction until the trend dictates otherwise. The strategy has it basis as when sentiment is very poor, the market will constantly get bombarded by bad news and the self-fulfilling prophecy will cause a complete loss of confidence in the market. Likewise, in a bull run, people typically forget the common sense of investing in fundamentally strong and well-priced stocks. The bullish atmosphere drives investors into a buying frenzy.

One of the best aspects of momentum investing is the ability to make money regardless of whether the market is going up or down. When the market is bullish, you take long positions; when the market is bearing, you take short positions. Technical analysis is extremely important in this strategy as one must be able to time the exit without getting burnt by a sudden change in market direction. However, it is important to note that momentum investors often buy when the stock is already overvalued and sell when the stock is already undervalued.

A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding (or short-selling) investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any other asset class.

Contrarian investing is not foolproof though as some companies may go bust like the recent Lehman Brothers and Enron. Contrarian investing cannot be deployed without first studying the companies and ensuring that they are fundamentally strong and undervalued to begin with. Contrarian investing requires immense discipline and mental strength as you are going against the crowd. People will keep giving you all kinds of advice and your confidence may be shaken, only the strong willed will be able to pull off contrarian investing successfully.

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