Does Contrarian investing outperform the traditional approach? - Andrew Baxter

 

The goal for any investor is to make money. Most of us would prefer to make a lot of money, and in a short period of time. But the shorter the time-frame, and the more money you want to make, the greater the Risk in being able to achieve those goals. For this reason, investment strategies have nearly always focussed on Buy and Hold approaches where the selection of a sound businesses should have the ability to produce a capital gain, if not, at the very least a dividend return.

But the traditional method of investing may not provide the returns you ‘need’ to achieve your financial goals. Hence more speculative strategies are adopted in an effort to make more money quicker. Some become quite adept at achieving this, but for the majority of us, the elusive ‘key’ that unlocks this universal goal remains well out of reach.

What are the methods of investing?

Investing has several different methodologies that can be adopted. Traditionally, Value or Growth investing approaches are the two methods that most would adopt to choose positions for their portfolio.

Value investing is where stocks are selected because they are trading at prices below their evaluated market value, with an expectation that the share price will rise to trade at a more reasonable fundamental value. Whereas Growth investing seeks stocks that have the potential to increase their earnings, and subsequently attract investors to push the stock price higher.

In comparison, there is an alternative approach adopted by investors referred to as Contrarian investing. Contrarian investing is a method where the investor goes against the market trend or direction, buying when prices are performing badly and selling when they are performing well.

Each variation of strategy on how to choose a listed company to invest in has its advocates and opponents. In this professionals’ opinion, one approach is not better than the other. This is because over time, there will be market/economic conditions where one or numerous approaches will perform, and there will be times when one or numerous approaches do not perform.

The key to consistent investing …

Choosing an approach and sticking to that approach is the key to consistency in investing. Professionals won’t chop and change their approach, so what makes you think that a private trader/investor will have a better ability at picking changing market conditions?

Understanding the strengths and weaknesses of a strategy will provide insight when there is a better opportunity for performance, or to identify periods where it will under-perform. That way, you can gain confidence that if you are going through a poor performance period, that in time the strategy will improve with results.

Why adopt a Contrarian investing approach?

I was trained as a “trend trader”. That is, define the broad direction of the stock/market, and identify entry and exit levels to capitalize on the direction of the trend. Contrarian trading suggests trading against the trend.

To be successful using the contrarian method, there are additional methods you can adopt. For example;  You have identified a company that you believe to be fundamentally strong. Your view is that it has a good Growth potential in the coming years. But the share price has been retracing over recent months.

Going through the Lows

Now, I don’t like “catching a falling knife”. That is, buying stocks as they are falling. Not until I have evidence that the selling pressure is easing, and that buyer demand is starting to improve. To identify this, I use technical analysis techniques such as Support/Resistance, Candlestick (price) and volume movements.

Of course, we won’t always get this right, but with a defined plan that has a well thought out approach, more often than not we can identify opportunities for investment.

During the Highs

The same approach can be devised for when markets are pushing into highs. Overbought markets can offer an opportunity to either close trades profitably or to implement Short trading strategies that benefit from falling stock prices.

When managing a portfolio of positions, that is, multiple positions at once, having the ability to implement some of those positions as contrarian trades can provide a balance against fluctuating markets. Let’s say you held 5 stock positions in your portfolio and following a strong rise in the markets over the last couple of months you were concerned there might be a decline on the short-term. By implementing a contrarian trade to add a short position to your portfolio, you have the opportunity to hedge against a potential fall.

At Australian Investment Education (AIE), we manage strategy recommendations for various market approaches. These include the Covered Call (or Buy Write) strategy, various Option Spreads, Directional and Non-directional views, and a combination of Trend and Contrarian approaches.