Contrarian Investing
One of the basic ideas in finance is that if something is widely known, then it is already priced in by the market. This leads to the contrarian style of investing, as pictured below:
If an idea isn’t believed by the market, then taking a position against the market view generally leads to a better risk/reward pay off because the idea can’t be priced out of the market when it is already priced in. Of course, it is often very difficult to determine what market positions are contrarian because figuring out why the market is moving outside of earnings announcements, economic data and changes in government policy is a full time job in itself.
One way to clarify this is to focus on what people don’t like thinking about.
Trading based on what people don’t like thinking about can consist of taking the long term point of view, or just the politically incorrect point of view. An example of a politically incorrect view is that of vice stocks, stocks in industries that could be considered questionable. These types of stocks outperformed the S&P up until the start of 2008, by which time the idea that investing in vice outperforms could be said to no longer be contrarian.
Another area that investors avoid is the long term. Investors may acknowledge long term trends are important but their incentives are short term. They are paid and allocated capital based on yearly performance. This leads to a focus on the short term, where earnings reports and economic data more than a year away are seen as insignificant. This is partially why the value based investor strategy works (in the sense that value stocks have consistently outperformed growth stocks in many basic quant models) – if a company is cheap relative to its price then the investor will make money in the long term despite the lack of a positive story in the short term. Of course, sometimes the stock is cheap because it has a negative story in the short term, so the value stock is also a contrarian idea.
