Investment Strategy: Contrarian Investing 101

By: Joel Teo
Submitted: 2007-01-17 16:23:29
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Have you ever wondered why some people are able to invest in any financial instrument or property at a low price and why you have always missed the boat? This article explains the importance of understanding why contrarian investing works and how having such a mindset can help you make more money as part of a larger investment strategy.

1. Value Investing mindset

Before one can profess to be a contrarian investor, you must have an understanding of the underlying value of the thing you are buying and decide that it is undervalued and historically and the market will rebound within a good period. A good book to start reading on value investing in the stock market is “The Intelligent Investor”, by Benjamin Graham who was Warren Buffets’ Professor in Columbia University and helped shape his investment strategy. So because you know the usual market value of something, you can purchase it on the cheap when prices drop , not unlike shopping for discounts at a supermarket.

2. Look out for downturns

Another key indicator is to understand your market well and then pay a careful attention to downturns in the economy or freak incidents like September 11. Some investments do down in value due to macro economic factors that may have nothing to do with your particular investment. A contrarian investor would spend time looking for ominous signs in the papers which may lead to a downturn so as to purchase stocks, shares at a discount to the average price.

Downturns that can prove profitable include:
• Natural Disasters that have nothing to do with the underlying stock.
• Cross Border Disputes affecting a particular Company’s price which has nothing to do with its main operations.
• Wars and Hostilities that can affect the competitors of your current favourite stock.

3. Look out for excessive exuberance

Contrarian Investors know that downturns can also be profitable if you use Put options which pay you when the underlying stock declines in price? The best way to predict such a downturn would be to look for in the words of the former Chief of the Federal Reserve Allen Greenspan, “excessive exuberance”. This means basically that while prices are still rising furiously, the number of buyers would start decreasing and a market correction might follow.

Some indicators of such excessive exuberance include:

• When you see financial analysts being very rosy on highly speculative stocks.
• When the stock market indexes start rising close to record highs.
• When you notice that trading volume diverges with the price, meaning that while prices are rising, the trading volume is dropping.

Contrarian investing is thus a mindset where the individual looks for trading opportunities which can yield profits. A contrarian investor thus looks out for economic, political and other factors which can cause a large market movement in the particular financial instrument that he is trading in and can make a large capital gain from his investment. This form of investing can be part of a larger investment strategy and one should consider contrarian investing as part of his online investing warchest today.

Copyright © 2006 Joel Teo. All rights reserved. (You may publish this article in its entirety with the following author's information with live links only.)

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