What is contrarian investing?

"Contrarian" is a term that gets bandied about by lots of people in the investment world.

You have to take it with a pinch of salt. It means a lot of different things to a lot of different people.

The classic is the fund manager who talks about being "a bit of a contrarian", when what he really means is that his portfolio holds 1% fewer HSBC shares than the FTSE 100 index. We're not exactly talking big, bold bets.

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Or there's the notion that a contrarian just does the opposite of what everyone else does. Clearly, that's pretty stupid too. If you sell every time the market starts to go up, then buy every time it starts to go down, you'll do nothing but lose money.

So what is contrarian investing really all about?

The stupid way to be a contrarian

John Authers had an interesting piece on contrarian investing in his FT column some time ago, highlighting just how tricky it is to define the term.

Authers noted that one of the difficult things about contrarian investing is that "the market is quite often right. It is not as simple as just betting against the market".

The reality is that most of the time, you'd be better going with the market rather than betting hard against it. As Authers notes: "The force of momentum is very strong, and winners generally keep on winning longer than they should".

So does that mean that contrarian investing is a waste of time? No. But it doesn't really make any sort of sense to look at the stockmarket on 1 January, and then buy what went down the most over the past 12 months, and sell what went up.

Valuation has to come into it, for a start. Say a stock has risen in price by a lot over the past year. Does that mean that it's expensive? No – it might be, or it might not be. But the direction of travel over the past year has no bearing on that fact. Nor does the direction of travel reveal much about sentiment and the popularity or otherwise of the investment.

After 2000, when tech stocks had been falling hard for some time, was it a contrarian play to buy them at the start of 2001? Not at all. They were still overvalued.

As Andrew Lapthorne of Societe Generale points out, also in the FT, "generally on a 12-month view you don't get reversals. You get reversals on a two- to three-year view."

In short, it's not contrarian to buy and sell mechanically like this – it's facile.

What a contrarian really does

Here's what I think makes more sense as a definition of contrarianism.

A contrarian is someone who uses a range of techniques to identify with a high degree of conviction situations where the market is badly wrong about something. They then position themselves to profit from what will happen when the market wakes up to that fact.

So it's about spotting potential turning points in advance, and preparing for them. The timing does not and should not have to be perfect (too much luck involved), and the execution of the trade needs to take that into account.

So it's not about thinking: "That went down a lot. I should buy it". Or: "stocks have been going up for ages, this bull market must be near an end".

It's more about thinking: "Which low-probability scenarios is the market pricing in as high-probability outcomes today, and how can I bet against that (or at least avoid making the same mistake)?" And then you let the trade run until the situation has reversed itself.

Investors are scared of missing out – they're always itching to "buy the dips". But they're also jittery enough to want to press the "sell" button at the first sign of a proper correction happening.

So rather than worry about whether the US market is close to peaking or not, I'd pay more attention to what's actively cheap. Just remember there are no shortcuts to good investment returns. The fact that everyone acts as if there are is one major reason why the market makes the sorts of mistakes that allow contrarian investors every so often to make outsize profits.