In investing, as in life, the biggest winners are the ones who took a different path. Contrarian investors march to their own drum beat. In this article we will find out what is contrarian investing, how to spot contrarian opportunities, and what mindset to cultivate to be a successful contrarian investor. We will learn why investing legends like Michael Mauboussin and David Dreman swear by contrarian investment strategy. We will also investigate its overlap with value investing – both strategies hinge on buying undervalued assets, but they employ different lenses.
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What is Contrarian Investing?
Contrarian investing is buying assets that are out of favor with the market. A contrarian investor profits by selling the asset when it comes back into favor. For example, if you had bought stocks during the depths of the Covid-19 crash in 2020 when the entire market was selling off, you would have acted contrary to the market. As a contrarian investor, you would have purchased most stocks very cheap and when the market recovered, you could have made significant profits if you sold.
Contrarian investors live by the philosophy “Buy when others are fearful, sell when others are greedy”. This is similar to Warren Buffett’s mantra. The goal is to stay rational when the market is euphoric or panicking and use the temporary market inefficiencies to scoop up attractive assets.
As you can very well imagine, your mindset will define how successful you are as a contrarian investor.
How Contrarian Investing Works?
The markets may be rational for most parts, however, one cannot overlook the effect of the emotions on the prices. Very often, investors overshoot in either direction – prices rise beyond what the value can support when the investors are euphoric, and the prices fall below what is reasonable when the investors are pessimistic. The sentiment is amplified when other investors see get into the frenzy and small mispricings can become quite large.
As a contrarian investor, you will go against the market sentiment – you will buy when everyone else is panicking, and you will sell when everyone else is buying. Your approach includes the following 2-step process:
Step 1 – Identify Mispricings: You will look for assets that are trading below the intrinsic value due to pessimism or neglects. The easiest places to find these assets are in the sectors that are currently out of favor. Many sectors are cyclical and these opportunities arise often. For example, tanker shipping is currently out of favor and can yield great value opportunities. Other possibilities arise when a stock crashes due to a temporary earnings miss – in such cases you are making a bet that the market has over-reacted and the stock price will recover enough to yield a good profit.
Step 2 – Wait for Mean Reversion: Mean reversion is a concept that asset prices eventually return to their intrinsic value. In the context of a stock, this means that a stock may be at times be over valued and other times it may be under valued, but in either case you would expect the price to revert to the intrinsic value of the stock. All you need to do is to take a position and wait for the market to correct its mispricing.
By now you have surely noticed that contrarian investing is almost the polar opposite of momentum investing. Indeed, momentum investors bet on the stock continuing the trend it is on, while a contrarian investor bets on the stock eventually reversing the trend. There is a little bit of nuance here – a stock may have an upward momentum if its fundamentals are also improving at a significant clip. It is possible that while the stock price is rising, the intrinsic value is rising as quickly, and therefore the stock may not be mispriced. A contrarian investor will know not to bet against such a stock. Nvidia, comes to mind.
A contrarian investor runs the risk of being saddled with a value trap. A momentum investor runs the risk that the momentum may shift against him without warning. These risks come with the territory – a good investor will develop systems and processes to mitigate these risks over time.
Some of the common contrarian investments today include small-cap value stocks and real estate stocks.
The Link Between Contrarian Investing and Value Investing
Contrarian investing and value investing share many of the traits. For example, in both strategies, you will conduct fundamental analysis to select stocks. Value investors also look for assets that are temporarily out of favor with the market.
However, while value investors use many quantitative metrics such as P/E ratios or discounted cash flow models, a contrarian investor places heavier emphasis on market sentiment and psychology. Ultimately, the difference may boil down to how they both approach stock screening. A contrarian investor will start from the extrinsic factors first, for example out of favor sector, bad news, changes in interest rates, etc. and then later drill down into fundamentals of an equity. A value investor on the other hand is very likely to start the screening process by looking at the financial ratios, metrics and some combinations thereof and then later take the extrinsic factors into account before deciding to pursue an investment.
Contrarian investing adds an additional layer of insight to traditional value investing: the ability to understand and exploit market psychology. While value investors rely on metrics to guide their decisions, contrarians thrive by going against the prevailing sentiment. When the two strategies are combined, investors can maximize their chances of finding bargains, not just based on numbers, but also on timing and sentiment shifts.
This combination—buying undervalued companies during periods of market pessimism—is what makes investors like Warren Buffett, David Dreman, and Michael Mauboussin so successful.
Lessons from Michael Mauboussin on Contrarian Thinking
Michael Mauboussin, a renowned investor, author, and expert in behavioral finance, provides essential insights into how contrarian investing can unlock hidden opportunities. His research focuses on how markets form expectations and the role of behavioral biases in creating mispriced assets. In this section, we’ll explore Mauboussin’s views on contrarian thinking, the paradox of skill, and how investors can develop an edge by betting against the crowd at the right times.
According to Mauboussin, the price of an asset is a reflection of the market’s expectations about its future performance. If the consensus expects great things, the price will already reflect that optimism. Conversely, if expectations are low, the price will reflect pessimism. The key to successful investing, Mauboussin argues, lies in identifying when market expectations are too high or too low and positioning yourself accordingly.
- High Expectations = Risk: When sentiment is overly optimistic, even a small disappointment can trigger a sharp decline.
- Low Expectations = Opportunity: If sentiment is overly pessimistic, good news or a return to normalcy can cause a sharp rebound.
One of Mauboussin’s most well-known insights is the Paradox of Skill. This concept explains why even skilled investors struggle to outperform the market in competitive environments. As more talented professionals enter the market, the average skill level rises, and outperformance becomes harder. However, as skill increases, luck and behavioral mistakes play a larger role in determining winners and losers. In these competitive markets, contrarian strategies thrive because many investors fall prey to herd behavior, making irrational decisions based on fear or greed.
Mauboussin emphasizes that behavioral biases—such as herding, overconfidence, and loss aversion—create mispricings in the market. Contrarian investors can profit by recognizing these biases and acting independently.
- Herding: When investors follow the crowd, they often drive prices higher or lower than justified by fundamentals.
- Loss Aversion: Many investors sell at the first sign of trouble to avoid losses, even if the company’s long-term prospects remain solid.
- Overreaction to News: Investors frequently overreact to bad news (e.g., disappointing earnings), which creates buying opportunities for contrarians.
Essentially, be on the lookout for market over-reactions and take a contrary position. When the market reverts to the mean, you will profit.
Actionable Insights from Mauboussin’s Framework
Here are a few practical takeaways from Mauboussin’s contrarian philosophy:
- Find Low-Expectation Stocks: Look for companies where the market has priced in failure—these stocks don’t need to exceed expectations by much to deliver significant returns.
- Look for Asymmetry: Focus on opportunities with limited downside risk and significant upside potential, where expectations are pessimistic but fundamentals are stable.
- Use Behavioral Indicators: Watch for extreme sentiment in markets, such as high short interest or bearish analyst ratings, as potential contrarian signals.
- Be Patient: Many contrarian opportunities take time to play out. Don’t expect quick gains—successful contrarian investing requires conviction and patience.
David Dreman’s Playbook: Betting Against the Crowd
David Dreman, a pioneer in contrarian investing and author of “Contrarian Investment Strategies: The Next Generation,” built his career by challenging conventional wisdom and proving that markets overreact to both good and bad news. His approach emphasizes psychological discipline, value metrics, and avoiding the herd mentality, offering a practical framework for those looking to profit by going against the crowd. In this section, we explore Dreman’s key principles and how his strategies continue to shape modern contrarian investing.
Dreman’s Core Principles of Contrarian Investing
- 1. Don’t Trust the Crowd
- The majority of investors tend to follow trends, chasing popular stocks during bull markets and panic-selling during downturns. However, the crowd is often wrong at turning points.
- Dreman suggests that successful investors must develop the courage to act independently—buying when everyone else is fearful and selling when others are euphoric.
- During the 2000 dot-com bubble, many technology stocks reached astronomical valuations due to mass enthusiasm. Contrarian investors who avoided these stocks—or bet against them—were rewarded when the bubble burst.
- 2. Focus on Low P/E and Low P/B Stocks
- Dreman’s research showed that stocks with low price-to-earnings (P/E) or price-to-book (P/B) ratios consistently outperform the market over time. These metrics help identify companies that are out of favor but have solid fundamentals.
- The market tends to overreact to short-term setbacks, but companies with strong fundamentals often recover, making them ideal contrarian picks.
- A company that misses earnings estimates for a quarter may see its stock price drop significantly. Dreman would view this as an opportunity to buy a quality stock at a discount, believing the sell-off was an overreaction.
- 3. Buy Stocks After Negative News
- Dreman’s studies revealed that bad news creates opportunities—stocks that drop sharply due to poor earnings or management changes often recover faster than expected. The key is to identify situations where the fundamentals remain intact, despite temporary setbacks.
- During market-wide downturns, even strong companies experience significant declines. Dreman would argue that buying these stocks during periods of pessimism offers the highest potential for long-term gains.
Psychological Barriers to Contrarian Investing
Contrarian investing is not easy. Going against the crowd is never easy. There are a few reasons for this.
- FOMO (Fear of Missing Out): The urge to follow the crowd, especially in bull markets. You see everyone around you making lots of profits, and you do not want to miss the train.
- Social Pressure: It’s difficult to stand alone when everyone else seems to be making money on popular trends. Would you really ignore the “no-brainer” stocks and buy something that no one cares about?
- Confirmation Bias: Investors prefer to seek out information that supports their current views, making it hard to go against prevailing sentiment. If you have decided something is a good buy, and there are millions of tid-bits everyday that support your view, it will be very hard for you to take a step back and say, perhaps this time is not really different!
- Patience and Discipline Required: It often takes time for the market to correct mispricings, meaning contrarian investors must endure long periods of underperformance. How long are you able to wait? If you think you are patient, consider the fact that you are standing along and all around you people are chasing other high flying stocks and you have no real idea when the tide will turn.
Humans are pre-wired for fight or flight, and this biological makeup makes it extremely hard for most of us to be good contrarian investors. Fortunately, this is a skill that gets easier with practice, so if you are committed to the contrarian investing strategy, remember, it gets easier.
Is Contrarian Investing Right for You?
Contrarian investing can be immensely rewarding, but it’s not for the faint of heart. Success requires independent thinking, emotional discipline, and the courage to defy the crowd. It’s also essential to combine contrarian insights with sound fundamentals, as both Michael Mauboussin and David Dreman teach us. Whether you’re a seasoned value investor or just looking to explore new strategies, adopting a contrarian mindset can open doors to overlooked opportunities.
So, the next time fear or hype sweeps the market, ask yourself: Are you ready to take the contrarian path?
If you said yes, than use some of the guidelines we have laid out in this article, be consistent, and over time you will start to find success.
