A contrarian investor makes investing decisions that are often opposite conventional wisdom or the actions of the crowd.
Contrarian investing is based on two primary ideas. First, contrarians believe that conventional wisdom and the actions of most investors are based on emotions, especially fear and greed. During a market crisis or a company scandal, for example, many investors will, out of fear or the pessimistic momentum of the crowd, sell their investments regardless of the intrinsic value of the company.
Similarly, during bull market runs, many investors will, through greed and the optimistic momentum of the crowd, buy securities that have seen their prices run up regardless of the intrinsic value of the company.
In both cases, crowd behavior can have the effect of mispricing stocks away from the value of the underlying company.
Second, contrarians generally eschew short-term investing for long-term buy and hold investing because it produces better real returns over time. Under this theory, investors buy shares of companies, not stocks, and focus on buying companies that are undervalued. Therefore, they tend to buy during periods of market panic (which have driven stock prices down below a rational assessment of the company), and they tend to sell during bull market runs, when stock prices often greatly exceed any underlying assessment of the company's value.
Contrarians often buy out-of-favor companies or companies in out-of-favor industries.
Warren Buffett, a famously contrarian investor, once summed up this investing philosophy by saying that investors should be greedy when others are fearful and fearful when others are greedy.
A classic example of contrarian investing occurred when Buffett purchased roughly $13 million worth of American Express shares after the stock had dropped nearly 50% in the wake of the salad oil scandal of 1963. The company's operations had not changed, and the stock tripled over the following two years.
Although it appears that contrarian investors are responding solely to the actions of the crowd, they are more likely to be responding to the mispricing opportunities created by short-term events and emotionally-driven investing, much like value investors.
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