Here's a piece courtesy of Marotta Asset Management on what it means to be a contrarian investor. This article is written by David John Marotta, President of Marotta Asset Management:
Much of my financial instincts were developed watching my parents manage money on a daily basis. Even now, one of the highest compliments that I can be paid is for someone to say, "The apple didn’t fall far from the tree." Last week my father authored specific examples of contrarian investing. This week I’d like to show how contrarian investing is at work when you regularly rebalance your portfolio.
A contrarian is an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn’t chase what is hot, but is often buying a category that has recently underperformed.
Major news sources move markets just by the tone of optimism or pessimism they adopt. The financial news is often focused on daily price movements and like all sports trivia, it tends to emphasize winning or losing streaks.
Stock prices can move on very low volume if the volume is all in one direction. Even if the vast majority of those who hold stocks are continuing to hold them, if even a few investors are motivated to buy or sell the price moves significantly.
In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. There is so much opportunity in the markets that even conservative investors get swayed by the siren songs of greed or fear. The strait between Sylla and Charybdis are a narrow path safely navigated only if you have a nymph like Thetis to guide you.
In the financial world your Thetis is a long term investment strategy and discipline that purposefully avoids moving in one direction. Not following the crowd is the definition of being a contrarian. And the cornerstone of being a contrarian is rebalancing your portfolio regularly.
Imagine you have a $100,000 portfolio consisting of two different categories called A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, Category A has earned 30 percent and Category B has just broken even. You now have $115,000: $65,000 in Category A and $50,000 in Category B.
You are happy with your investment in Category A, but you still aren’t sure about Category B. All the financial news is about Category A’s stellar returns, how the industry is booming, and how Category A’s products are essential to life on this planet. The news is also about the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.
To make matters worse, your neighbor to the right works in Category A and his 30 percent investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in Category B and adding to his investment in Category A. So, you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.
"Yes," answers your financial advisor, "You should sell $7,500 of Category A and invest that in Category B." You are stunned. Your first thought is that your investment advisor is so stubbornly enamored by Category B that he won’t admit his mistake and insists on pouring more of your investment gains down the drain.
While you are not convinced by this ‘asset allocation’ strategy you decide to give it another try. So you sell some of Category A and buy more Category B. Now you have $57,500 invested in each.
Fortunes change. The layoffs and new leadership in Category B return profitability and the industry begins to recover. Stock prices, which were beaten down because of losses rebound from their lows, and Category B gains 30 percent the second year.
Meanwhile, Category A’s growth falters. Stock prices had been driven up from new investments and were now pricing the company for 30 percent annual growth. When the industry of Category A only experiences 15 percent growth, the stock prices falter and appreciation ceases. Despite 15 percent growth, current stock valuations are barely justified and drift sideways for a 0 percent gain for the year.
Your brother-in-law and your neighbor to the right are tight-lipped.
Your neighbor to the left, however, is ecstatic. He works for a company in category B. Not only is his company doing better, his investment made a 30 percent return this past year!
You are happy, but not ecstatic. You’ve never gotten a 30 percent return. You return to your investment advisor and ask him, "If you knew that Category B was going to do well, why didn’t we put all the money in that category?"
"I didn’t know Category B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15 percent the first year and 15 percent the second year. Unlike your neighbors, the second year’s gains compounded with the first year's gains to produce a total gain of 32.5 percent"
You are stunned. The simple contrarian act of pulling money out of the investment which was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5 percent. Not only did your investments do better than your neighbors’, but you avoided the feast or famine volatility inherent in their approach.
As a financial advisor I can often foresee which category will perform the best over the next year by which category new clients are the most reluctant to invest in. It is tough being a contrarian, but investing in beaten down categories is too important for your investment returns to let emotions get in the way.
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As you might imagine, I'm not really in agreement with the thought that financial advisors are "in the know" and the rest of us aren't when it comes to investing, but I do agree with his philosophy as it relates to contrarian investing.
I think your lack of agreement with him on that one point is due to a minor misunderstanding. He's NOT claiming that "as a financial advisor I can often foresee..." in order to claim that his foresight is due entirely to his status as a financial advisor. He's explaining how he gains information about the market thanks to his position as a financial advisor. He does that by watching how reluctant his (financial advisory) clients are to invest in given sectors and stocks.
He's not claiming that this is the only way to gain information about the market; he's just saying that it's a good way for him. His way obviously wouldn't work for anyone who's not a financial advisor, since we don't have financial advice clients :-). Talking to friends wouldn't be a bad idea, as long as you kept in mind that your friends probably aren't investing in the things they "blabber" about; putting your money where your mouth is (as a financial planner's client must) has a way of pulling out how you REALLY feel. It's a lot easier to TALK contrarian than it is to walk it. So expect your friends to give you a "false feel" for how willing they are to invest in contrarian ways.
Posted by: William Tanksley | October 31, 2006 at 12:20 PM