What is Contrarian Investing
Markets are typically divided in two classes: bulls and bears. A bull market is a market that is going up, usually associated with euphoria and optimism for the future. A bear market is a market that is going down, a time when investors panic and pessimistic sentiment prevails, leading to a lot of selling and skepticism in investing money back into assets.
The average investor will trade with the market, which means: when the market is going up, she’s confident that the market will keep the uptrend and she opens a position; when the market is going down she thinks that time has come to save the investment and will close her positions. It’s a fairly common behavior and something that feels intuitive, mainly because of a bias that leads us to think that something that has happened in the recent past for some time will keep happening in the immediate future.
Some people, however, take a different look at things and think that a reversal is due sometime in the future, so what they do is trade against the market: if the market is in an uptrend they will short, if it’s in a downtrend they will buy.
Such weird people are called contrarians, because they do the opposite of what the majority of investors are doing in the same timeframe.
No pain, no gain
Being a contrarian is not easy: it means looking at the current situation and seeing what everybody else is not seeing, like some signs of reversal that are invisible to the majority of people but are still clear enough to make you think that they could really happen in a not-so-distant future.
This means being something of a detective, investigating the news, political or financial reports for objective hints that could strengthen your hypothesis, while everybody else is going in the opposite direction and will most likely think that you’re crazy or dead wrong — maybe colleagues, friends and family will even try to talk you out of your insane idea.
It means keeping a cold blood and being able to think rationally even though your gut is telling you to join the herd and feel safe. It means being loyal to your theory even if it takes weeks, months or even years to become true, all the while looking for hard facts that confirm your idea and reassure you that you haven’t gone crazy.
But.
If you have the right insight and manage to get through all of this, you are most likely in for some serious gains, because being a contrarian investor is a bit like gambling: if you gamble on something that is considered unlikely to happen, the reward is proportionally big. This is why contrarian investors typically manage to collect huge profits from a single trade.
Most of the times, when the market is following the trend, market movement won’t be very big, so it’s not likely to see major downs in an established bear market or very high ups in a bull market that’s been going on for some time. The same does not apply for market reversals: in this case some sharp drops or pumps are not uncommon, and this is why behaving as a contrarian can be so profitable (especially if you can manage to short the right timeframe).
So yes, being a contrarian is a lot more work than going with the flow but it also pays off a lot more.
Some famous contrarian investors
Some people have made their way into history with their brave bets, which have resulted in huge gains during historically important moments. We will have a look at the most recently famous of them.
- John Paulson’s feat during the subprime mortgage crisis is narrated in the book “The Greatest Trade Ever” by Gregory Zuckerman: Paulson was a good but not exceptional fund manager until 2006, when he bought credit default swaps for betting against the subprime mortgage bonds that were going crazy in those years. In 2008 he got paid 550 million dollars by Goldman Sachs for that single bet.
- Michael Burry is the hedge fund manager portrayed by Christian Bale in the movie “The Big Short”, which is based on the homonymous book by Michael Lewis. He’s the founder and manager of Scion Capital, a hedge fund based in California, which was getting considerable profits even during years of bear markets. He too, like John Paulson, bought credit default swaps in order to bet against the housing bonds before the bubble burst in 2008, gaining him $100 million and another $700 million for his investors. However, Burry thought that the market would collapse sooner than it actually did, getting him close to losing the capital.
- Bill Ackman, founder and CEO of Pershing Square Capital Management, became famous for his short position in Herbalife’s stock, which went on for many years until he was forced to close it and move to other more profitable trades. He recently got on the news again because of this short trade during the Coronavirus pandemic: while people were still hopeful that it wouldn’t be a great deal in the occidental world, he foresaw that the pandemic would create big problems in the world’s economy and took a short position in the market for about $27 million, which resulted in a staggering profit of $2.6 billion.
What you can take away from all this
Look at the fundamentals: don’t just read the charts and blindly trust the news (chances are that by the time you read the news, it’s already priced in the asset), try to see if the intrinsic value of an asset can support the value assigned to it by the market; if that’s not the case, dig deeper in the facts and do your homework (and be sure that the numbers add up).
Breathe deeply and try to follow your instinct: chances are that if you feel that something is not right, that’s where you should keep looking for something that proves or disproves your theory.
Be patient: being a contrarian can be nerve-wracking but you need to keep your cool, otherwise you risk throwing away all the hard work and the research you have already done.
Being a contrarian is not easy but it can bring you some serious rewards.
