Contrarian versus Momentum Investing

Contrarian Investing: What Is It

It is an approach to investing in which the investor takes position about the market in a direction opposite to the prevailing market trend. So, if the market is moving upward, the contrarian investor would take the view that it has become overvalued and would soon start coming down. So, instead of buying the stock, he would be selling them. Similarly, if the market is moving down, the contrarian investor would take the view that it would soon be into the oversold zone, i.e. undervalued, and in a matter of time, would start moving up. The scope of the contrarian investing could be stock-specific, sector-specific, or the market-wide, based upon the views of the investor.

Contrarian investors usually look for stocks which are in process of or have become undervalued or overvalued due to some reasons like price movements based upon positive or negative news. While most of the investors, due to their herd mentality, would still be buying or selling on the expectation of the further continuation of the price movement, contrarian investor would be looking for values above or below which the stock would become overvalued or undervalued. And, he would take long or short position based upon this assessment even if most other investors are taking opposite positions. Generally, there are two types of contrarian strategies: prior returns strategy and valuation measures strategy.

Prior returns strategy assumes that extreme price movements in one direction will be followed by subsequent extreme movements in opposite direction. So, past losers are expected to become future winners. The logic underlying this proposition is that stocks which have performed well in past are bid up by the investors in over-reaction to ultimately become overpriced. Similarly, the stocks having fared poorly in past are oversold to the limit of becoming undervalued by the over-reacting investors. The contrarian investors assess the time of arrival of the two extremes to take their positions.

In valuation measures strategy, the ratios like price-to-earning, price-to-book value, book-to-market value etc. are either expected to be a proxy for past performance or to disclose the future performance expectations of the stock. The contrarian investor chooses only those stocks which are either over-valued, or under-valued, or have potential future upside or downside.

Momentum Investing: What Is It

It is an approach to investing in which the investor tries to make profit out of continuance of the existing market trend, whether upside or downside. The momentum investor believes that the current market trend is to continue for a while, and entering the market even now would provide positive return on investment based upon the expected horizon of continuity of current trend. So, if the market is moving upward, the investor would take long position to gain from expected further appreciation of stock prices. Similarly, in a downward moving market, the investor would go short to buy profitably at lower prices on expectation of further depreciation of stock prices.

Momentum investing depends upon the expected propensity of the relative winning stocks to keep winning and the losing stocks to keep losing. So, whenever the market or the stock movement changes its direction, momentum investors are expected to incur losses. The market or stock momentum may or may not be based upon sound fundamentals. So, if investors are investing in a stock having upward price trend due to some momentum but otherwise having weak company fundamentals, they are in fact aggravating the market inefficiency.

Momentum investing is mostly attributed to the herd mentality of investors, over-reaction to some event, and confirmation bias.

Strengths of Contrarian Investing

• It seeks to gain from the misguided market or stock movement, thus is directed towards the actual market or stock-price level. In this way, it helps in increasing the market efficiency in long term.


• It helps keeping the investor out of succumbing to herd mentality where mostly the early movers walk away with largest share of profit.


• If applied using valuation measures strategy, it can give returns higher than average market return over long term in efficient markets.

Weaknesses of Contrarian Investing

• It is a risky strategy, as it goes against the conventional wisdom of following the market direction.


• There is relative information deficit regarding contrarian investment opportunities in the market, so much depends upon the assessment of the individual investor. If that goes wrong, the investment would not yield expected results.


• There must be some cushion for short term depreciation of investment value while using the contrarian investing. For example, suppose some stock is trending up since long and the contrarian investor expects a trend reversal. So, he would short that stock at certain price level. It is possible that the trend reversal happens, but after price increases further from the price level the investor entered. In that case, the investment value will decrease and he may even get a margin call if there is no sufficient amount in his trading account.


• The investor usually needs a long term investment horizon to earn a good rate of return.

Strengths of Momentum Investing

• It provides the opportunity for capital appreciation at relatively low risk, as usually the trend continues for some time, and there are enough signals of trend reversal during which the investor can take out his investment.


• There is relative abundance of market information about an ongoing trend and the expected level after which it may reverse. So, the momentum investor does not need to go for his own research about the timing of investment.


• Even if some investor is late in joining the trend, he can wind up his position at little or no loss at earliest signal of a reversal.


• Unlike the contrarian investing, the investment horizon need not always be long term. It depends upon the stage of trend when the investor decides to take position.

Weaknesses of Momentum Investing

• Common investors usually do not pick up the trend at early stages. They join when most of the potential gains have been apportioned by either the financially expert or the institutional investors.


• Sometimes, the trend reversals may be very sharp, and may erode all the gains made by investors entering late. Also, recoveries from retracements may not be good enough to give the investors chance to wind up profitably.


• The investment horizon of momentum investing is usually short. So, short term capital gains tax can make the strategy less attractive.


• Going long in a stock based upon momentum, which otherwise is not fundamentally sound, aggravates the market inefficiency.


• Market needs to be watched continuously for catching early trend reversal signs. So it needs more effort by the investor to be safe.

Conclusion

Contrarian investing has similarities to value investing, and if done in disciplined manner, can give good returns in long term. It helps enhance market efficiency by exploiting the valuation inefficiencies. However, risks are inherent as contrarian calls may go awry if the expected trend reversal does not materialize. In that case, losses may be huge. So, this investment strategy is not advisable for risk-averse investors.

Momentum investing is relatively less risky as it is based on just following the market trend. But again, it is important to make entry and exit at right points. For that, trend formation and trend reversal are two events to be looked for. Despite that, moderate gains could still be made using this strategy. However, the tax structure could potentially decrease the net returns making it less attractive.

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