According to the Random House Unabridged Dictionary, the definition of contrarian is “one who rejects the majority opinion, as in economic matters.” While it is important to understand what this says, it is even more important to understand what it does not say. Many investors believe the definition of contrarian strategy consists of nothing more than looking at what the market as a whole is doing, and doing the opposite. The crowd is running North? Run South. (This applies to many “contrarian” mutual fund managers, by the way.)

This misses the point. Think about it. If you always do the exact opposite of what the crowd is doing, you’re still controlled by the crowd. What’s more, the crowd isn’t always wrong. As the saying goes, even a broken clock is right twice a day.

The Herd Mentality

Ignorance, Greed, Fear and Hope. As Edwin Lefevre wrote in the investing classic Reminiscences of a Stock Operator, these are the greatest enemies of investors everywhere. Regrettably, they are also the primary driving forces behind most investors’ decisions. Ignorance causes them to rely on the word of self-styled pundits, brokers with ulterior motives, or other talking heads that are long on extravagant claims and short on performance. Greed causes them to jump on spurious promises of outsized gains from penny stock pumpers, internet hucksters, and other shady characters. Fear causes them to sell winning positions too early, wanting to “lock in gains.” Hope causes them to ride losing positions all they way down into the gutter, hoping in vain for a recovery.

Investors tend to move in herds. A market analyst from a big, impressive-sounding institution changes his rating of a stock from “hold” to “buy,” and the herd stampedes to their brokers to load up. The herd never wonders why the analyst never publishes reports of his historical results. He’s a highly paid professional, so he must know what he’s doing, right? The herd never considers that the institution’s only incentive is to get them to trade as often as possible, so they can collect their commissions. They just run for the troughs to load up.

The contrarian, on the other hand, sees analysts, pundits, and brokers for what they are: a bunch of emperors with no clothes. The contrarian views all mass movements of the herd with great suspicion. Rather than spend time studying trends, the contrarian looks for hidden treasure in the form of great companies that have been ignored by Wall Street mouthpieces.

Why be a Contrarian?

James Montier, author of Behavioural Finance: A User’s Guide, puts it best:

“A recent paper by Dasgupta et al shows that the stocks which institutional fund managers are busy buying are outperformed by the stocks they are busy selling! Over a two-year time horizon Dasgupta et al found that, on average, the stocks that fund managers had bought most over the last five quarters underperformed the stocks they had sold most, by 17%! They found that this strategy worked for large and small caps, and value and growth stocks, so regardless of your universe, being a contrarian seems to make sense.”

In our minds, the true definition of contrarian strategy is simply thinking for yourself. If the herd is running north, we might run South. But we might also run East, West, or sometimes even North. But always for our own reasons, never just because of the way the herd is running.

In fact, a contrarian often makes his biggest profits along with the herd. We invest in boring, forgotten, undervalued companies, then ride the wave when the crowd finally discovers them. It’s hard to lose when you buy things for less than they’re worth.

Being a contrarian can be scary at times. It can take courage to go the other way when everyone you talk to is gushing about how they’re getting rich in the hot trend in fuel-cell stocks, junior mining corporations, oils sands stocks, or whatever the next paper tiger turns out to be. But which takes more courage, in the end? Thinking for yourself, or following the herd — off a cliff?

So start a revolution — think for yourself. And only take advice from someone who has a vested interest in your success.