The Philosophy Behind Contrarian Investing And How To Make This Strategy Work For You

Contrarian investing refers to the practice of actively doing the opposite of what most market investors have chosen to do. In effect, a contrarian investor might look to sell stock when others are buying or buy shares of this same stock when others are selling it at a discount price.

There’s a method to the madness, though, and the philosophy behind a contrarian strategy is largely rooted in seeking out opportunities that an investor believes the broader market has missed or mispriced. Here, we take a closer look at how contrarian investing works – and how, with a little research and market savvy, it holds the potential to pay off for you.

How Do Contrarian Investing Strategies Work?

Contrarian investors are individuals whose investment philosophies go against the grain. They consistently aim to buy when others are selling (and stocks are relatively cheap) – and to sell when others are buying (and stocks are more expensive).

Put simply: A contrarian likes to identify instances of unwarranted overexuberance or lack of enthusiasm among other investors and actively bet against them, believing (by way of example) that overvalued stock will eventually correct down to a lower price, and undervalued stock will eventually experience an uptick in price instead. When a contrarian investor spots an opportunity, they might buy up a cheap stock and look to hold it until it increases in value. Alternately, they might seek to short a stock in the hopes that they will be able to buy it more cheaply at a later point in time.

One way to look at contrarian investors is as the bulls in a bear market, and the bears in a bull market – those who actively go against conventional wisdom to instead pursue an opposing investment strategy.

Show Me The Math: An Example Of How A Contrarian Investor Profits

Imagine, for example, that in the wake of rising market concerns that most investors sell off stocks in cruise lines, airlines and hotels, believing that business will go down in the near future – and are willing to price a share of any one of these stocks for $10 instead of $20. A contrarian investor might scoop up these shares at this lowered price, anticipating that that consumer demand will rebound in the long run. The hope is the business will experience an uptick in value and the contrarian investor to sell the shares of stock they bought for $10 for $20 later down the road … or potentially even more, if there’s a major uptick in bookings.

Or, a contrarian investor might choose to short these stocks (borrow stock from another party who owns them, then resell them in turn) instead, if they still believe that these stocks are overvalued.

Continuing with the above example, the contrarian investor might elect to borrow 20 shares of stock from a lending broker at the current market rate ($10) and sell them, bringing in a total of $200. If the price of these stocks subsequently falls to $5, the contrarian investor can then buy the outstanding shares back at the new price ($100), return the shares that they borrowed to their trading partner, and pocket $100 ($200 – $100) in profit. However, on the downside, if stock prices unexpectedly rise to $15, the contrarian investor would lose $100 instead – and there’s no telling how much a stock may actually plummet despite the best predictions, leading to potentially unlimited downside exposure.

Is Contrarian Investing Considered Safe?

Short sellers make highly speculative and risky bets on short-term fluctuations in the marketplace. Buy-and-hold investors also take risks but do so with an eye toward making more long-term investments. All come with some measure of potential downside attached.

Short Selling

Shorting, or short selling, occurs when an investor borrows shares of stock from another party who owns these assets, then sells them in turn. This is done in the hopes that the stock will fall in price, and that the borrower can scoop up shares of the same company later at this lower price before returning these shares to the lender and then pocketing the difference in asking price. But shorting is a much riskier practice than buying stocks, in that it can lead to almost unlimited exposure if the price of the borrowed stocks increases instead.

Bearing this in mind, short selling is absolutely not a guaranteed safe investment. Participate in it, and you’re effectively making a bet that a stock will decrease in value by a specific date. Note that even the most astute and well-informed investors do not know exactly when a stock’s price will rise or fall. That said, it also holds the potential to be highly profitable if you correctly anticipate the future of the market.

Buy-And-Hold

On the other hand, paying attention to worthwhile contrarian thinking (which posits that other investors may have errantly over- or underpriced a stock) definitely has the potential to pay off long-term if you make the right bets. Buying stocks when they are undervalued and holding onto these assets until the rest of the market agrees and prices rise has long been a favorite strategy of value investors.

Value investors, in essence, are not motivated by bucking current trends so much as they are the inherent value of a company. When they feel that the market has missed an opportunity or priced an enterprise’s stock incorrectly, aren’t shy about investing their funds with an eye toward the future.

What Does It Take To Be A Successful Contrarian Investor?

To be a successful contrarian investor, you must not only understand the intricacies of the stock market, but also the ebbs, flows and activities of individual stocks and companies. It also helps to do your research and have a good sense of which way investor sentiment is blowing.

A successful contrarian investor must also be able to withstand the psychological strain of separating their actions from conventional wisdom and possess the resilience to stay the course with their investments when others are selling. This often means having to hold underperforming stocks for a long period of time before (hopefully) ultimately cashing in on huge profits.

Think of it this way: A contrarian investor needs to be confident enough in themselves and their investment philosophies to stick with them even when it appears times are tough. That means being able to trust in your vision and investments enough to ride out any rollercoaster-like patches and disruptions encountered in the market as you wait to make a profit.

Are There Famous Contrarian Investors?

The short answer: Of course. No two investors think alike, and many – like billionaire Warren Buffet, the Oracle of Omaha – have set themselves apart from the pack by being able to spot things others can’t.

Another notable contrarian investor who made a killing in the market is hedge fund manager Michael Burry, of “The Big Short” fame, who bet against the roaring subprime mortgage market. Burry made a fortune in the 2008 recession following the collapse of this industry – yet another example of how taking a contrarian investment philosophy can pave the way for huge returns.

The Bottom Line: Contrarians Buck The Herd Instinct To Make Their Profits

Herd mentality tends to dominate among investors: It’s the reason that so many retail investors are pouring money into fields like cryptocurrency and electric vehicles, even though both are nascent markets with uncertain futures and highly volatile valuations.

Rather than stick with the pack, contrarian investors earn their money by cashing in on the inherent weaknesses of groupthink – allowing them to reap substantial rewards by following the timeless advice to “buy low and sell high.”

As an investor, it not only pays to do your research when considering where to invest your capital, it also pays to trust your instincts when evaluating whether market forces are acting irrationally. It’s also best to avoid getting caught up in your emotions when investing. 

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