Investing – Contrarian vs. Trend Following

When you are ready to start investing, you need to realize there is no “one-size-fits-all” approach. Just as your style of clothing doesn’t exactly match your friends or families, your own investing methods may not work best with others. Finding the right one is key to unlocking your potential as a smart investor. Otherwise, you can try the trial-and-error method and figure out which one works best for you. But be warned, this comes at the cost of your wallet and possibly even your tears.

The most effective way to figure out your investing style is to start asking questions. A lot of questions. For example, here’s a quick list of questions you can ask.

  • What is my investment goal?
  • How much risk can I tolerate?
    If you don’t know the answer to this question, you may want to check out Risk For Investing.
  • In the case that I lose all my investments, will I be okay financially?
  • Why am I investing? Better yet, why am I investing in this particular stock?
  • How diversified is my portfolio?
  • Do I have the time and resources available to study my investments?
  • What is my timeframe? In other words, how long can I invest for?

If you haven’t already, check out 3 Ways You Can Become a Better Investor to understand basic investment concepts and strategies.

Investment Strategies

There are several strategies that investors use to help them succeed. Look through any finance textbook and you’ll find there are countless strategies to choose from. For example, take a brief look at the two most commonly used strategies that investors use:

  • Active Investing: Investors with a high tolerance to risk tend to focus on this particular strategy. Active investors keep a close eye on market trends and they have the time and resources to study stock performances. They are usually more concerned with short-term profits rather than see the long-term growth potential.
  • Passive Investing: Otherwise known as income investing, this strategy focuses on receiving a steady stream of funds through the investors’ portfolio. Investors don’t need their stock prices to spike. Instead, they prefer their stocks to perform consistently well for a longer period of time.

While knowing all the available investing strategies is great, there are two specific ones we would like to focus especially on: contrarian and trend-following.

Contrarian Investing 101

As the name implies, a contrarian investor is one who goes against the grain of popular beliefs and the general investing sentiments. When everyone is buying, you sell. And when everyone is selling, you buy. Essentially you do the exact opposite of what everyone else does — sticking true to the meaning of the word “contrarian.”

The principles behind contrarian investing can be applied to individual stocks, an industry as a whole, or even an entire market. Investors who adopt this style understand that “hype” or “trends” can often be misleading in the stock market. Meaning, people usually say the market will go up or down based on their own purchasing power. If they are fully invested in one company, they tend to believe the stock will go up — only because they have already sold out.

Contrarian investors come into the market only when they know others are feeling pessimistic about it. They essentially believe that the negativity among other investors push stock prices below its actual value, thus presenting a good buy opportunity. The investor will buy as many stocks as possible before the broader sentiment returns and the share prices go back to its normal price. Contrarian investors go against the idea that markets should be controlled by the herd instinct and believe that broad sentiments don’t make for a good investing strategy.

Perhaps the most well-known contrarian investor you may know of is Warren Buffett. During the financial crisis in 2008, when companies were filing for bankruptcy, Buffett carefully counseled investors to purchase American stocks. His advice seemed irresponsible at first. But ten years later, the S&P 500 went up by 130%. One of the stocks he had invested was the investment bank Goldman Sachs Group Inc. In ten years, this stock jumped by 196%.

Contrarian & Value Investing

Contrarian and value investing are similar in several ways. Often times, people mistake one for the other because both styles look for share prices that are lower than the intrinsic value of the company. But the key difference between the two styles is in the scale and execution — a value investor relies more on fundamental metrics to pick up companies while a contrarian leans more heavily on market sentiment and exaggerated price movements. For example, value investments are carefully curated by measurements like P/E ratio and contrarian investments are chosen based on the general market consensus.

Trend Following 101

Quite the opposite of contrarian investing is the trend following strategy. Trend following sticks to a “normal” way of trading stocks; you buy when the price trend goes up and you sell when the price trend goes down. There is no hidden tricks or magical formula with this strategy as it pertains solely with trends. With this strategy, one does not aim to forecast or predict but simply keep an eye on the market for any emerging phenomenon.

Trend following strategy has existed for more than 200 years. Jeremy Siegel in his 1998 second edition of “Stocks for the Long Run” mentions that a trend following strategy produces similar results to buying indexes and reinvesting dividends for a long period of time. And within this strategy, there is a time series momentum, which is going long for positive returns and shorting those with negative returns. Looking at time series momentum between 1880 through 2013, trend following strategies have performed fairly well.

Source: A Century of Evidence on Trend-Following Investing

Investors who employ this particular style normally enter the market when they know the trend has “properly” established itself and will stay for a long period of time. However, as soon as they see a turn in the trend, they will exit the market and wait until the stock returns to its original price. Not only is this the key point to trend following, but the best way to ensure success is being able to diversify portfolios. The only way to achieve consistent positive results is to trade markets across the board. This will give the investors a good chance to earn a nice return with less volatility.

With trend following strategy, there are four ways to consider if a stock is worth a buy or not:

  • Price: Investors should focus only on the current price, not what it might be in the future. One of the dangers of trend following is putting too much emphasis on trends and not on the actual conditions. Knowing this can be of huge help to investors who need the right state on the market.
  • Quantity: For trend followers, timing the market is an important skill to have. And equally important, one should be able to decide how much he should trade over the course of the trend.
  • Risk: Cut losses is the golden rule for trend following investors. This means that when markets are volatile, investors should preserve their capital until more positive trends appear.
  • Diversification: Cross asset diversification, as mentioned above, is an essential part of professional trend following tactic. Does the stock add value to your overall portfolio? Modern investors often trade dozens of futures markets across equities, bonds, currencies, and commodities.

Final Thoughts

Before you make your first investments, you need to decide which style fits you best. There are countless options to choose from and it’s important to know what works for you and what doesn’t. With the two mentioned here, if you prefer to go with market sentiments, you may try out trend following. But if you prefer to go against the majority, than contrarian may fit better. Whichever one you choose, however, you need to be comfortable with the level of risks involved and the potential outcome with your preferred timeline.

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