The Draw and Risks of Contrarian Investing!

     When markets are in free fall, there’s quite a lot of  recommendation that’s meted out to traders, and one is to simply purchase the dip, i.e., purchase crushed down shares, within the hope that they are going to get better, or the complete market, whether it is down.  “Shopping for the dip” falls right into a broad group of funding methods that may be labeled as “contrarian”, the place traders act in distinction to what the remainder of the market is doing on the time, shopping for (promoting) when the overwhelming majority are promoting (shopping for) , and it has been round by means of all of market historical past. There are strands of analysis in each behavioral finance and empirical research that again up contrarian methods, however as with all the things to do with investing, it comes with caveats and constraints. On this publish, I’ll posit that contrarian investing can take completely different kinds, every based mostly on completely different assumptions about market conduct, and current the proof that we’ve on the successes and failures of every one. I’ll argue that even in case you are swayed intellectually by the arguments for going in opposition to the gang, it might not be just right for you, in case you are not psychologically attuned to the stresses and calls for that contrarian methods convey with them.

Contrarianism – The Totally different Strands

    All contrarian investing is constructed round a standard theme of shopping for an funding, when its worth goes down considerably, however there are vast variations in how it’s practiced. Within the first, knee-jerk contrarianism, you utilize a bludgeon, shopping for both particular person firms or the complete market when they’re down, on the expectation that you’ll profit from an inevitable restoration in costs. Within the second, technical contrarianism, you purchase beaten-up shares or the complete market, however provided that charting or technical indicators help the choice.  Within the third, constrained contrarianism, you purchase the shares which might be down, however provided that they go your screens for qualify and security. Within the fourth, opportunistic contrarianism, you utilize a worth markdown as a possibility to purchase firms that you’ve at all times wished to carry, however had not been in a position to purchase as a result of they had been priced too excessive.

1. Knee-jerk Contrarianism

    The best and most direct model of contrarian investing is to purchase any traded asset the place the worth is down considerably from its highs, with the asset typically being a person firm, typically a sector and typically the complete market. Implicit on this technique is an absolute perception in imply reversion, i.e.,  that what goes down will nearly at all times return up, and that purchasing on the crushed down worth and being prepared to attend will subsequently repay.

    The proof for this technique comes from many sources. For the market, it’s usually constructed on papers (or books) that take a look at the historic information on what fairness markets have delivered as returns over lengthy durations, relative to what you’d have made investing elsewhere. Utilizing information for the USA, a  market with the longest and most dependable historic data, you may see the substantial payoff to investing in equities:

It doesn’t matter what time interval you utilize in your time horizon, shares ship the best returns, of all asset lessons, and there some who take a look at this document and conclude that “shares at all times win in the long run”, with the implication that you need to keep totally invested in shares, even by means of the worst downturns, you probably have a fairly very long time horizon. These returns to purchasing shares develop into higher, while you purchase them when they’re cheaper, measured both by means of pricing metrics (low PE ratios) or after corrections. There are two issues with the conclusion. The primary is that there’s choice bias, the place utilizing historic information from the USA, one of the crucial profitable fairness markets of the final century, to attract basic conclusions in regards to the threat and returns of investing in equities will lead you to underestimate fairness threat and overestimate fairness returns. The second is that, even with US equities, an investor who purchased shares simply earlier than a significant downturn must wait a very long time earlier than being made complete once more. Thus, traders who put their cash in shares in 1929, simply forward of the Nice Melancholy, wouldn’t have recovered till 1954. 

    With particular person shares, the strongest backing for getting the dip comes from research of “loser” shares, i.e., shares which have gone down essentially the most over a previous interval. In a broadly cited paper from 1985, DeBondt and Thaler labeled shares based mostly upon inventory worth efficiency within the prior three years into winner and loser portfolios, with the highest fifty performers going into the “winner” portfolio, and the underside fifty into the “losers portfolio”, and estimated the returns you could possibly have made on every group within the following metropolis months:

As you may see, the loser portfolio dramatically outperforms the winner portfolio, delivering about 30% extra on a cumulative foundation than the winner portfolio within the thirty six months after the portfolios are created, which DeBondt and Thaler argued was proof that markets overreact. A few decade later, Jegadeesh and Titman revisited the examine, with extra granular information on time horizons, and located that the outcomes had been reversed, in the event you shorten the holding interval, with winner shares persevering with to win over the primary yr after portfolio creation. 

The reversal finally kicks in after a yr, however over the complete time interval, the winner portfolio nonetheless outperforms the loser portfolio, on a cumulative foundation. Jegadeesh and Titman additionally famous a skew within the loser portfolio in direction of smaller market cap and lower-priced shares, with larger transactions prices (from bid-ask spreads and worth affect). As different research have added to the combo, the consensus on winner versus loser shares is that there is no such thing as a consensus, with proof for each momentum, with winner shares persevering with to win, and for reversal, with loser shares outperforming, relying on time horizon, and questions on whether or not these extra returns are giant sufficient to cowl the transactions prices concerned.

    Setting apart the blended proof for the second, the largest hazard in knee-jerk contrarian investing on the market stage is that purchasing the dip out there is akin to catching a falling knife, since that preliminary market drop generally is a prelude to a a lot bigger dump, and to the extent that there was an financial or basic cause for the dump (a banking disaster, a extreme recession), there could also be no close to time period bounceback. With particular person shares, that hazard will get multiplied, with traders shopping for shares which might be being offered off to for reliable causes (a damaged enterprise mannequin, dysfunctional administration, monetary misery) and ready for a market correction that by no means comes. 

    To look at the sorts of firms that you’d put money into, with a knee-jerk contrarian investing technique , I checked out all US shares with a market capitalization exceeding a billion {dollars} on December 31, 2024, and located the businesses that had been the largest losers, on a p.c foundation, between March 28 and April 18 of 2025:

You’ll notice that know-how and biotechnology companies are disproportionately represented on the checklist, however that’s the by-product of a bludgeon method.

2. Technical Contrarianism

    In technical contrarianism, you begin with the identical foundation as knee-jerk contrarianism, by   shares and markets which have dropped considerably, however with an added requirement that the worth has to satisfy a charting or technical indicator constraint earlier than changing into a purchase. Whereas there are numerous who consign technical evaluation to voodoo investing, I imagine that charting patterns and technical indicators can present indicators of shifts in temper and momentum that drive worth actions, no less than within the close to time period. Thus, you may view technical contrarianism as shopping for shares or markets when they’re down, however provided that the charts and technical indicators level to a shift in market temper.

    One of many issues with testing technical contrarianism, to see if it really works, is that even amongst technical analysts, there appears to be no consensus as to the very best indicator to make use of, however broadly talking, these indicators may be based mostly on both worth and/or quantity actions. They vary in sophistication from easy measures like relative power (the place you take a look at proportion worth modifications over a interval) and shifting averages to complicated ones that mix worth and quantity. In current many years, traders have added pricing in different markets to the combo, with the VIX (a traded volatility index) in addition to the relative pricing of places and calls within the choices market being utilized in market timing. In sum, all of those indicators are directed at measuring worry out there, with a “market capitulation” considered as an indication that the market has bottomed out. 

    With market timing indicators, there’s analysis backing up using VIX and buying and selling quantity as predictors of market actions, although with substantial error.

Because the VIX rises, the anticipated return on shares in future durations goes up, albeit with a lot larger volatility round these anticipated returns. It is ironic that a number of the greatest defenses of technical evaluation have been provided by teachers, particularly of their research of worth momentum and reversal. Lo, Wang, and Mamaysky current a reasonably convincing protection of technical evaluation from the angle of economic economists. They use each day returns of shares on the New York Inventory Alternate and NASDAQ from 1962 and 1996 and make use of subtle computational strategies (relatively than human visualization) to search for pricing patterns. They discover that the most typical patterns in shares are double tops and bottoms, adopted by the broadly used head and shoulders sample. In different phrases, they discover proof that a number of the most typical patterns utilized by technical analysts exist in costs. Lest this be trigger for an excessive amount of celebration amongst chartists, additionally they level out that these patterns provide solely marginal incremental returns (an educational code phrase for actually small) and provide the caveat that these returns could not survive transaction prices.

3. Constrained Contrarianism

    In case you are within the old-time worth investing camp, your method to contrarian investing will replicate that worldview, the place you’ll purchase shares which have dropped in worth, however provided that they meet the opposite standards that you’ve for good firms. In brief, you’ll begin with a listing of crushed up shares, after which display screen them for excessive profitability, sturdy moats and low threat, hoping to separate firms which might be low-cost from those who need to be low-cost.

    As a constrained contrarian, you might be hoping to keep away from worth traps, each worth investor’s nightmare , the place an organization appears to be like low-cost on a pricing foundation (low PE, low worth to ebook) and proceeds to develop into even cheaper after you purchase it. The proof on whether or not screening helps keep away from worth traps comes largely from research of the interaction between proxies of worth (resembling low worth to ebook ratios) and proxies for high quality, together with measures for each working/capital effectivity (margins and returns on capital) and low threat (low debt ratios and volatility). Proponents of high quality screens notice that whereas worth proxies alone not appear to ship extra returns, incorporating high quality screens appears to protect these extra returns.  Analysis Associates, an funding advisory service, checked out returns to pure worth screens versus worth plus high quality screens and presents the next proof on how screening for high quality improves returns:

The proof is supportive of the speculation that including high quality screens improves returns, and does so extra for shares that look low-cost (low worth to ebook) than for costly shares. That mentioned, the proof is underwhelming when it comes to payoff, no less than on an annual return foundation, although the payoff is bigger, in the event you consider volatility and estimate Sharpe ratios (scaling annual return to volatility).

    Whereas a lot of the analysis on high quality has been constructed round worth and small cap investing, the findings may be extrapolated to contrarian investing, with the lesson being that relatively than purchase the largest losers, you need to be shopping for the losers that go screening exams for prime profitability (excessive returns on fairness or capital) and low threat (low debt ratios and volatility). Which will present a modicum of safety, however the issue with these screens is that they’re based mostly upon historic information and don’t seize structural modifications within the economic system or disruption within the trade, each of which haven’t but discovered their means into the basics which might be in your screens.

    To supply simply an illustration of constrained contrarianism, I once more returned to the universe of about 6,000 publicly traded US shares on April 18, 2025, and after eradicating companies with market capitalizations lower than $100 million (with the rationale that these firms may have extra liquidity threat and transactions prices), I screened first for shares that misplaced greater than 20% of their market capitalization between March 28 and April 18, after which added three worth screens:

The six firms that made it by means of the screens are beneath:

I’m certain that in case you are a worth investor, you’ll disagree about each the screens that I used in addition to my reduce offs, however you might be welcome to experiment with your individual screens to seek out bargains.

4. Opportunistic Contrarianism

    In a fourth variant of contrarian investing, you utilize a market meltdown as a possibility to purchase firms that you simply have at all times wished to personal however couldn’t as a result of they had been overestimated earlier than the worth drop, however look beneath priced after.  The most effective place to begin an evaluation of opportunistic investing is with my publish on why good firms usually are not at all times good investments, with the primary being decided by the entire issues that go into separating nice companies from dangerous companies, together with progress and profitability, and the second by the worth it’s important to pay to purchase them. In that publish, I had an image drawing the distinction between good firms and good investments:

Put merely, most nice firms are impartial and even dangerous investments, as a result of the market costs them to be nice. A yr in the past, once I valued the Magazine Seven inventorys, I argued that these had been, for essentially the most half, nice companies, with a mix of progress at scale, excessive profitability and deep moats, however that on the costs that they had been buying and selling  they weren’t nice investments. 

I additionally argued that even nice firms have their market travails, the place for durations of time, traders lose religion in them and drive their costs down not simply to worth, however beneath. It occurred to Microsoft in 2014, Apple in 2017, Nvidia in 2018, Tesla at a number of occasions within the final decade, and to Fb, on the top of the Metaverse fiasco. Whereas these corrections had been brought on by company-specific information tales and points, the identical course of can play out, when you have got important market markdowns, as we’ve had over the previous couple of weeks. 

    The method of opportunistic contrarianism begins nicely earlier than a market correction, with the identification of firms that you simply imagine are good or nice companies:

On the time that you simply first worth them, you might be more likely to discover them to be over valued, which is able to undoubtedly be frustration. It’s possible you’ll be tempted to play with the numbers to make these firms look undervalued, however a greater path is to place them  in your checklist of firms you wish to personal, and go away them there. Throughout a market disaster, and particularly when traders are marking down the costs of all the things, with out discriminating between good and dangerous firms, you need to revisit that checklist, with a caveat that you can not examine the post-correction worth to your pre-crisis valuation of your organization. As an alternative, you’ll have to revalue the corporate, with changes to anticipated money flows and threat premiums, given the disaster, and if that worth exceeds the worth, you should purchase the inventory.