How Does Contrarian Investing Work?

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Written By Adam Hudson

Using contrarian investment strategies to enhance retirement returns

Using contrarian investment strategies to enhance retirement returns

If like many pension holders, you are constantly thinking about how best to ensure an easy and comfortable retirement, it might be worth spending some time thinking about the sort of investment strategies you use to get there. Contrarian investment strategies can be a powerful – but risky – tool for enhancing your portfolio returns.

Most long-term equity strategies for retirement planning involve buying and holding shares of well-chosen companies, or a basket of them, without worrying too much about market timing.

How Does Contrarian Investing Work?

Contrarian strategies, by contrast, involve looking for undervalued shares that are being overlooked by the general market. These shares are often uniquely likely to have long positive runs, and by entering such trades early, you can transform your portfolio performance.

There are several ways to find shares like this. By researching the earnings reports and annual results of major companies, you might find unpopular companies or sectors that are quietly turning over strong profits on a stable balance sheet, all while being ignored by the broader market.

The best place to look is in ‘unfashionable’ industries like consumer goods or tobacco. Because they are rarely in the news, such companies can trade at lower valuations for longer, despite having equal or superior growth prospects to their more flashy cousins.

In particular, companies or sectors recently hit by large sell-offs, such as financial firms in 2009 or tech companies immediately after the dot com crisis of 2001, are a very attractive prospect for contrarian investors. Mass market movements often reflect changes in sentiment rather than real underlying conditions and so usually move with excessive force – whether that be in an upward or downward direction.

In the run-up to 2007/2008, bank shares exploded in value, as investor excitement over the prospects of the sector and a string of announced mergers pushed their valuations far beyond any reasonable growth expectation. Conversely, immediately after the sub-prime mortgage crash and ensuing bank failures, financial stocks became some of the cheapest in the market in 2009 – 2010.

A skilled contrarian investor, looking at valuations and the general market sentiment, would’ve avoided these stocks in 2005 – 2008, but likely added them to his portfolio in 2009 or 2010.

How Does Contrarian Investing Work?

When not to use contrarian strategies

Though they are a powerful tool for any forex or stock trader, it is equally important to know when to avoid contrarian strategies. A few situations in which it would be wise to reach for another strategy are set out below:

i). During the early stages of a bubble

For example, many contrarian investors expressed scepticism about the value of bitcoin during its first massive price spikes in 2017. The old adage about markets ‘staying irrational longer thanks you can stay solvent’ holds true here.

ii). When a bubble is being driven by hard factors.

For example, the spike in bond prices is driven by investment funds seeking yield for their portfolios. These structural factors can drive prices outside of a reasonable valuation for a long time – in the case of negative-yielding bonds, seemingly forever.

iii). Anything involving commodities.

Supply issues and industrial demand, as well as issues in market access and liquidity, make these markets a poor choice for contrarian investors.

In general, contrarian long positions are a wiser bet than attempting to time the top of the market. Prices tend to fall suddenly and rise slowly; therefore it is possible to enter a long contrarian trade after the price has begun to move up from its bottom, but the reverse situation is often impossible.

Waiting for confirmation on a market top by looking for the first downward move will often see most of the potential gains wiped out. A wise contrarian may look to see if the bottom of the ensuing sell-off is excessive – possibly creating an opening for a long contrarian trade on the same asset.

Even bearing all of these factors in mind, it is easy to get things wrong as a contrarian investor. We advise extreme caution when trying to bet against market moves, and proper risk management strategies are essential.

Risk management for contrarian investors

The basic risk management tools; stop losses, position-sizing, and careful monitoring of live trades, are the same for contrarians as for everyone else. What is different is the relative importance they take.

A trend-following trader will likely only see stop losses triggered if he either sets them too tightly and they are hit by interday variation, or if the entire trade rationale disappears and the market moves against him.

Contrarians are in a trickier position because their stop losses may be triggered without the trade rationale disappearing. They still believe the market will change direction – in fact, each extension of the current trend strengthens their case – but they have mistimed when it will occur.

This can be dangerous as it adds to the temptation to set very distant stop losses, a move that necessitates having unrealistic profit targets to maintain the risk-reward ratio or even trading without stops.

Given even the most irrational trends can continue for great length, up to years or decades, trading without a stop loss is particularly dangerous for contrarian investors. It may be frustrating to see your trade repeatedly stopped out, but that is the nature of contrarian trading.

It is a strategy built more around big, occasional wins than always being right. Traders who need the continual reinforcement of repeatedly being proven correct by market moves are best off using trend-following strategies.

Risk management for contrarian investors

Technical analysis for contrarian investors

Typically contrarian investors, especially in equities, use fundamental strategies as the bedrock of their investment rationale. It is impossible to say that a trend is irrational if you aren’t looking into drivers of value beyond price moves and market psychology.

However, skilful use of charts still has its place in contrarian trading. Timing the exact position of a market top (or bottom) can be aided with the use of candlestick patterns or momentum indicators.

i). Candlestick patterns

Candlestick patterns such as the Doji star or head and shoulders pattern can indicate an impending market reversal.

The art of candlestick analysis has a centuries-long history and is immensely popular in the forex market. Candlestick charts can also be used in all other financial markets, but they are most used in FX.

ii). Momentum indicators

Momentum indicators such as the RSI or stochastic oscillator can help highlight when market conditions are overbought or oversold.

When the indicator flashes above a certain level (80), it is a sign that the market is experiencing a weakening of the technical case for its highs, and may soon reverse. Momentum indicators are used in all financial markets and are equally popular amongst FX and equities traders.

Both of these systems provide leading indicators which can predict future market price movements. It is important for contrarian investors to know about them, but also not to be overly concerned with the exactitudes of market timing.

As usually, a contrarian position is a longer-term investment, with an expectation to share in large price moves and retain the holding for a long time. Good market timing will enhance these returns, but they are not dependent on it and so fundamental analysis is very much at the fore for contrarian traders.

Contrarian strategies in different asset classes

As mentioned above, some asset classes are better suited to contrarian trading than others. Commodities are quite unsuited to contrarian trading, given their tendency for sudden moves, limited liquidity, and the risk of physical delivery.

The presence of industrial users and suppliers in these markets also changes the nature of price movements compared to markets where trading is dominated by financial firms or traders.

Equities, given their unique capacity for fundamental analysis, are probably the most natural home for contrarian investors. The long-term nature of contrarian strategies means they are particularly suited to equities, especially of major blue-chip companies. Similar strategies also exist in the fixed income and forex markets but they are less popular.

Some things to remember when using contrarian strategies

Some things to remember when using contrarian strategies

Contrarian strategies are long-term, so you should only enter into a contrarian trade in an asset you would be happy holding for a longer period. High-quality equities and to a lesser extent the debt of reliable counterparties are the best options. 

Always make sure you have some understanding of what has driven the market overreaction that has created the rationale for your contrarian investment. Even if the movement is irrational, it is worth considering how large it is and how long it may continue.

Remember it is always safer to be a contrarian investor on long trades: your losses are therefore limited, and also the general upward tendency of the equities market can work in your favour.

Contrarian strategies can be a powerful strategy to push your retirement portfolio to the next level. However, contrarian trades require extra discipline and research before they can be entered into. Thoroughly understand the asset you are buying and the different factors impacting its price before you enter into any contrarian trades.

By preparing thoroughly, you can reach your retirement goals sooner and with minimal risk to your overall wealth.

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