How a contrarian makes money in Stock market?

December 13, 2011   ·   0 Comments

http://stockssavvy.comWarren Buffett said “Be fearful when others are greedy and be greedy when others are fearful.” Contrarian investors, like Warren Buffett, sell when others are buying and buy when others are selling. Decisions of common investors are usually dominated by greed. They become bullish when the market rallies strongly and they panic and get out when prices crash. This overreaction causes price aberrations which are exploited by contrarian investors.

Sir John Templeton, the legendary investor, was a contrarian. In 1939, when World War II was breaking out, he bought $100 worth of every stock selling ‘cheap’ on the New York Stock Exchange, held it over a few years and made a killing. James Montier, a member of GMO’s (Grantham, Mayo, Van Otterloo & Co) asset allocation team, says holding a contrarian view and following it is one of seven immutable laws of investing. He points out that humans feel safe being a part of the herd—social exclusion is as painful as physical pain therefore, being a contrarian is like having your arm broken on a regular basis. To be a successful contrarian requires guts, knowledge of market dynamics and sound financial analysis. A contrarian uses his judgement to make a contrary move against the crowd when logic proves that the majority is wrong. As Benjamin Graham, the legendary author, said, “Even the intelligent investor is likely to need considerable willpower to keep from following the crowd.” Deciding when to enter a contrarian trade requires fortitude and confidence.

Montier says that focusing on value investing will lead you to be a contrarian. Value investing focuses on acquiring stocks when they are ‘cheap’ under the assumption that the price will correct and will return to the normal P/E. A contrarian investor would be buying when others are selling and assets are cheap and selling when others are buying and assets are expensive, asserts Montier. David Dreman, a pioneer of contrarian investment strategies, explains: “I buy stocks when they are battered. I am strict with my discipline. I always buy stocks with low price-earnings ratios, low price-to-book value ratios and higher-than-average yield. Academic studies have shown that a strategy of buying out-of-favour stocks with low P/E, price-to-book and price-to-cash flow ratios outperforms the market pretty consistently over long periods of time.”

This concept is similar to Montier’s first law—margin of safety, which focuses on buying shares at a discount to their intrinsic value. But identifying such a situation is difficult, as powerful psychological forces would prevent us from following a contrarian strategy. The truth is all of us can’t be contrarian investors; it defeats the very principle. But it’s advisable to watch our step to avoid being part of a financial massacre. As Rick Rule, founder of Global Resource Investments (GRI), puts it, “You are either a contrarian or a victim.”

In any case, it is good to remember what Mark Twain has written about being part of the crowd: “Whenever you find yourself on the side of the majority, it’s time to pause and reflect.” Studies in behavioural finance confirm that group members tend to take a riskier position than its individual members, on an average, would have taken. Humphrey Neill, author of the book The Art of Contrary Thinking says, “When everybody thinks alike, everyone is likely to be wrong.” A contra investor himself, Humphrey mentions in this book that a ‘crowd’ is influenced by emotions while an individual thinks with his brain. Therefore, consensus opinion of investors, provoked by the ‘noise’ of the media, causes them to behave illogically and make bad decisions.

Source: Moneylife

Rajesh Singla

Rajesh is the founder & CEO of Stockssavvy, Stocks analyst,financial advisor by choice,software engineer by fate,biker,gamer,cricket lover n enthusiastic person. He believes in doing things not just to get by but to get Ahead...

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