Investing in the stock market offers numerous opportunities for profit, but it also carries inherent risks. Market participants have used two popular investment approaches — the contrarian and trend following strategies — to try to enhance profits and minimize risk, to varying degrees of success.
In this blog post, we’ll explore the merits, drawbacks, and intricacies of each approach, providing insights for investors seeking to make more informed decisions in their pursuit of long-term success. We’ll also look at real-life examples of these strategies in action, including the pitfalls and challenges associated with each approach.
The Contrarian Approach: Seeking Value in Unloved Stocks
Contrarian investing involves seeking out-of-favor stocks with low valuations, as they often have most of the negative factors already priced in. While this approach may sound simple in theory, it requires a keen eye for detail, patience, and the discipline to execute an investment effectively.
Strengths: Contrarian investing can uncover hidden gems in the market, as undervalued stocks may offer significant growth potential once their true value is recognized by the broader market. This approach can also lead to lower portfolio volatility due to its focus on fundamentally strong companies trading at discounted prices.
Pitfalls: Identifying true value in out-of-favor stocks can be challenging, and investors must be prepared to weather disappointments and potentially prolonged holding periods. For instance, AT&T and Verizon are businesses that, on paper, appeared to be great contrarian investment opportunities due to their low valuations. However, the negative price action ultimately proved justified due to managerial overspending and a continuing decline in revenues. These cases illustrate the importance of being meticulous about which businesses you select for contrarian investing.
Example: Unilever, which underperformed due to the management’s search for a “purpose” for their brands, resulting in a price multiple difference between the European conglomerate and its US competitor Proctor and Gamble. Contrarian investors saw potential in Unilever’s valuable brands and the involvement of activist investors. Today, the company has caught up to P&G — and significantly outperformed this competitor — as it has focused on profit, changed its business divisions, and announced an external CEO with a great track record of growing brand-oriented businesses, who will be taking over in July 2023.
The Trend Following Approach: Riding the Momentum of High-Performing Stocks
Trend following investors seek to capitalize on the momentum of stocks with strong price performance, trusting that better-performing companies will continue to outperform their competitors. This approach requires investors to buy and hold more expensive stocks, often in the face of market noise and short-term fluctuations.
Strengths: Trend following can generate significant returns when executed well, as market leaders often continue to deliver strong performance over time. This approach can also benefit from the compounding effect of reinvesting gains into high-performing stocks.
Pitfalls: The trend following approach carries the risk of entering positions too late or failing to exit before a trend reversal. Additionally, trend followers may be prone to herding behavior, driving stock prices to unsustainable levels and creating market bubbles. In such cases, investors who do not exit in time may experience significant losses.
Example: In the beginning of the last decade, Apple began to outperform and grow bigger than Nokia, the leader in smartphone manufacturing at the time. Apple’s stock price became very expensive as it factored in a higher market share for phones, and many investors fled for less expensive Nokia shares. True trend following investors stayed invested in Apple, which dominated the smartphone industry over the next decade.
Strategies for Success in Contrarian and Trend Following Investing
To maximize the potential benefits of these investment approaches, investors should:
1. Develop a clear understanding of their risk tolerance, investment goals, and level of expertise.
2. Conduct thorough research on the companies they invest in, analyzing fundamentals, competitive position, and management quality.
3. Stay informed about market trends, economic indicators, and geopolitical events that may impact their investments.
4. Regularly review their investment portfolio, rebalancing and adjusting positions as needed based on changing market conditions and individual circumstances.
By considering these factors and understanding the potential pitfalls of each approach, investors can make more informed decisions and increase their chances of achieving long-term investment success.
At Grey Ledge Advisors, we believe that a successful investment strategy cannot be bound by a single approach but should rather be adaptive to various market environments. Our investment philosophy is rooted in a holistic blend of contrarian and trend following methodologies, allowing us to take advantage of opportunities across the full spectrum of market conditions. We strive to take a nuanced, opportunistic view of the market landscape, considering both the potential undervalued gems and the high-performing trendsetters in our decision-making process.
By integrating these complementary approaches, we aim to balance risk and reward, seek consistent returns, and ultimately, strive towards fulfilling our clients’ financial goals.
By Brant Walker
Like most processes, investment decisions moved more slowly in the pre-Internet days. When I started my investment management career nearly 40 years ago, a bank or analyst would send you a report through the mail — a multi-day process in itself — and you’d spend a day processing it before making your choices.
Today, anyone trying to invest on their own is being bombarded by information from all sides. Between 24-hour news networks, business news websites, social media chatter, and the ability to track a stock’s performance literally minute-by-minute, it can be difficult to choose how to proceed.
This noisy environment has only heightened the emotional aspects of investing. There has been extensive research into “behavioral finance,” or how human psychology affects investment decisions — often negatively. By better understanding this concept, you can put more trust into unbiased indicators, building your portfolio based on impartial information rather than gut feeling.
How emotions affect investment decisions
Many emotions come into play when you invest your money. You may be anxious about meeting your financial goals, excited to see your portfolio grow in value, eager to find investments that will produce a huge return on investment, nervous about market downturns, or depressed when an investment decision turns out to be a poor one.
Emotion-driven decisions can occur at any time. Some examples include:
- Investing in a company simply because you like their products
- Being less willing to take risks with your investment profits because you regard them as bonus income
- Stubbornly retaining a poorly performing stock rather than admitting that it was a mistake to buy it
However, emotion has the biggest impact on the market during periods of prominent gains or losses. During a strong market, people are more likely to underestimate risk, be overconfident in their own abilities, and chase after popular investments. During market downturns, people are more likely to panic and sell off investments in an effort to limit losses.
There are also several cognitive biases that affect investment decisions. One of the most common is confirmation bias, where people only consider evidence that supports their investment decisions and ignore other data, such as warning signs that a stock might be overvalued.
Anchoring bias is also a common factor that influences investment decisions. This occurs when you measure the performance of an investment on some irrelevant point of reference, like the price of a stock when you purchased it or a stock’s previous peak value.
Greed and fear
Greed and fear are the most powerful emotions affecting investment decisions. Greed spurs people to pursue higher gains by making riskier decisions, taking chances on speculative stocks, and pursuing short-term gains. Fear is the dominant option during bear markets or more volatile conditions, causing people to favor lower risk investments with smaller yields.
Concerns about losing your hard-earned money are a particularly potent factor in behavioral finance, leading to something called loss aversion bias. This occurs when a person gives priority to minimizing losses on their investments instead of actively pursuing gains.
Loss aversion bias can lead to considerably different investment decisions. Since people tend to be more risk-averse when faced with a positive income, they might sell a well-performing stock too early out of fear that its value might go down. Conversely, they may also engage in riskier behavior in an effort to avoid losing money, such as doubling down on a declining investment in hopes that it will recover.
Optimism and pessimism
Market trends drive the broader emotions of optimism and pessimism, which also tend to cause people to make buying or selling decisions at the exact opposite of the optimal time. When the market is on the upswing and stock values are rising, people are optimistic and more willing to buy. When values are declining, people are more pessimistic, less willing to buy, and more willing to sell the stocks they have in an effort to avoid losses.
You might notice that these decisions directly contradict the classic “buy low, sell high” investment strategy.
Two recent market downturns show how a pessimistic outlook can impact your investments. Tumbling stocks during the Great Recession drove investors to pull their money from the market, only for stock values to grow steadily over the next several years during the economic recovery. There was a similar response when the stock market cratered at the start of the COVID-19 pandemic, with stock values recovering even faster.
Once more, without feeling
When investing your money, you should always take the time to research your options and avoid quick decisions. While monitoring the performance of your investments is important, tune out the noise and do periodic check-ups instead of frequent adjustments; this can help you retain focus on a long-term strategy instead of responding to short-term trends.
Other strategies to take the emotion out of investing include:
- Using dollar-cost averaging, which invests a fixed amount of money at regular intervals. This guarantees that you’ll buy more shares during market lows (allowing them to capitalize during market gains) and fewer shares when prices are higher.
- Diversifying your portfolio to spread risk over different stocks and investment types. This strategy also allows you to invest more passively rather than try to pick hot stocks, which itself can lead to more stress and emotion-based decisions.
- Periodically rebalancing your portfolio to sell off stocks that have performed well and buy stocks that have not performed as strongly.
- Including stop-loss orders to set a limit on how much loss you’re willing to take on an investment. This helps ensure that you won’t hold on to an unprofitable investment too long.
- Segmenting your investments to support different goals, and creating a plan to meet these goals. For example, you might have a low-risk strategy to save money for a vacation and a higher risk strategy for long-term goals like retirement savings.
Working with an investment advisor will also help you avoid emotions when investing. This professional will provide you with unbiased recommendations and help you determine your goals and strategies.