Last week, I encouraged you to flex your contrarian muscles and scoop up beleaguered European bank stocks because, well… they're dirt cheap. And they won't be forever. Many readers responded by questioning my sanity. I'm immune to such criticisms by now, though. They come with the territory when you share unpopular investment ideas.
However, one reader confessed that he wanted to act on my recommendation, writing, "I agree with your thinking and analysis. But it's just so hard to actually be a contrarian." What are you talking about? Merriam-Webster defines a contrarian as "an investor who buys shares of stock when most others are selling, and sells when others are buying." It doesn't get any simpler than that!
In all seriousness, I understand that putting hard-earned capital on the line to buck conventional wisdom doesn't come naturally. On such merits, today I'm sharing my three rules of contrarian investing. Hopefully, they'll give you the confidence to put these theories into practice. Profitably, I might add.
Contrarian Investing Rule #1: Be a Skeptic, Not a Pessimist
As Humphrey B. Neill says, "The art of contrary thinking consists in training your mind to ruminate in directions opposite to general public opinions." Or, as my father likes to say, "No matter how flat you make a pancake, there are still two sides." Our job as investors is to make sure we're always taking both sides into account. It might not come naturally, since we're hardwired to seek out information that confirms prevailing wisdom or our own inclinations. (Psychologically speaking, it's known as "confirmatory bias.")
But as I've demonstrated countless times in Wall Street Daily columns, widely held investing beliefs seldom match up to reality. For instance:
- Consumer spending doesn't account for 70% of U.S. GDP, even though well-respected media outlets like MarketWatch and Bloomberg routinely say it does (for proof, go here).
- Super-fast economic growth isn't a precursor for a bull market in stocks.
- And a stock buyback isn't always a bullish indicator.
Indeed, a healthy dose of skepticism is always warranted. It allows us to see subtle market shifts that otherwise go unnoticed by the majority of the investing public. And it's by investing at these critical turning points that we stand to reap the most rewards.
Contrarian Investing Rule #2: Be Brave
There's no substitute for due diligence. But no matter how much research we do – and no matter how convicted we become about a specific contrarian opportunity – acting upon it will require William Wallace-sized bravery. Why? Because we're taking a wildly unpopular stance – and, as a result, we're going to be unmercifully ridiculed for it.
The good news is, in my experience, ridicule and stock market returns exhibit a near-perfect correlation. In other words, the more grief I get for a contrarian recommendation, the more profitable the investment typically ends up being. So if you've done your research, stand by it! No matter how many insults friends and colleagues sling your way, you'll have the last laugh. Eventually, that is-- which brings me to the last key to contrarian investing…
Contrarian Investing Rule #3: Be Patient
At its core, contrarian investing is a value-based strategy. And as we all know, it takes time for average investors to spot these bargains. As a result, it took a year before our contrarian bet on undervalued Japanese stocks that we made in WSD Insider started paying dividends. Now, this delayed gratification isn't always the norm with contrarian investments. I mean, after our research conclusively revealed in February 2012 that the real estate market was, indeed, bottoming out, the iShares Dow Jones U.S. Home Construction ETF (NYSEARCA:ITB) didn't waste any time hitting the gas pedal.
But in a day and age when the average investor only has enough patience to hold on to a stock for about five months, we need to have realistic expectations. Although our research indicates that a turning point is imminent, it's impossible to pinpoint exactly when it will materialize. So if we want to enjoy above-average investment results, sometimes we need to demonstrate above-average patience.
Bottom line: Follow these three simple rules, and while you might not become a more popular investor, I'm absolutely convinced you'll become a more disciplined and profitable one.