Contrarian investors zig when others zag. They look for neglected stocks that have been out of favor in recent months or years and use them as buying opportunities. However, these investors don’t buy a stock just because its price is dropping.
Investors who completely ignore fundamentals could end up with a losing portfolio.
Contrarian investing rules to follow
Warren Buffett, legendary investor and the chairman of Berkshire Hathaway, is a well-known contrarian investor. But investing like Buffett — or any of the pros — is a big challenge. Here are three things to keep in mind.
1. Focus on the long-term
If you’re going to buy a stock that other investors aren’t, you want it to grow in price over the long-term. That means negative sentiment around a contrarian stock must be temporary, such as due to short-term macroeconomic issues, political backlash or an earnings report in which the company missed guidance. These headwinds are not necessarily structural issues, and when they get resolved, the stock could extend its rally.
Contrarian investors ask if the long-term catalysts are intact. Some corporations strengthen their growth prospects while their stock prices fall. This type of mismatch fuels negative sentiment and presents a long-term opportunity for savvy investors.
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2. Look for strong fundamentals
If investors are selling a stock because the company has poor underlying fundamentals, that’s likely not a stock you want to buy.
You can assess metrics to get a sense of a company’s financial health. For example, the current ratio compares a company’s current assets against its current liabilities. Contrarian investors, like value investors, are often looking for strong companies that are being undervalued.
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3. Be patient
Contrarian investing often requires patience, since you may be holding on to a stock and waiting for its price to turn around for a significant chunk of time.
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Why contrarian investing isn’t for everyone
You don’t have to hunt for bargains and be a contrarian investor to reach your long-term financial objectives — and in fact, the strategy won’t work for many average investors. A much simpler approach is to buy a diversified index fund. These funds offer exposure to many assets and come at low costs.
Diversified index funds also eliminate the need to learn about complex ways to value stocks and determine which investments present compelling upsides. Contrarian investing is only profitable if you are right about the fundamental business. Not everyone can do enough research to validate their convictions, and picking the undervalued stocks that are going to take off is difficult even for Wall Street pros.
