Contrarian Investment Strategies

1. Human Psychology, Not Pure Rationality, Drives Market Behavior

Men, it has been well said, think in herds . . . go mad in herds, while they only recover their senses slowly, and one by one.

Herd mentality. Markets are not populated by perfectly rational actors as traditional economic theory assumes. Instead, human emotions and social dynamics significantly influence investment decisions, leading to collective manias and panics. This herd behavior has been observed throughout history, from Tulip Mania to the dot-com bubble.

Experiential vs. Rational systems. Our minds operate using two systems: a slow, analytical rational system and a fast, intuitive experiential system. In complex or uncertain situations, the emotional experiential system often overrides the rational one, leading to decisions based on feelings rather than logic. This is particularly true in the high-pressure environment of financial markets.

Historical parallels. The patterns of speculative bubbles and subsequent crashes are remarkably consistent across centuries. The excessive use of credit, abandonment of prudent principles, belief in a "new era," reliance on the "Greater Fool Theory," and the eventual panic are recurring themes, demonstrating that human psychological tendencies remain constant despite technological advancements.

2. Affect and Mental Shortcuts Lead Investors to Predictable Errors

Images, marked by positive and negative affective feelings, guide judgment and decision making.

Affect heuristic. Our strong likes and dislikes (Affect) powerfully influence our judgments, often subconsciously. Positive Affect towards an investment can make us perceive its risks as low and benefits as high, while negative Affect does the opposite, regardless of objective data. This emotional tagging distorts rational analysis.

Cognitive shortcuts. We use mental shortcuts (heuristics) to simplify complex decisions, but these can lead to systematic biases.

• Availability: We overestimate the likelihood of events that are easily recalled (e.g., shark attacks vs. falling airplane parts), leading us to overreact to recent or salient news.
• Representativeness: We see misleading similarities between current and past situations (e.g., comparing 1987 to 1929), ignoring crucial differences and prior probabilities.
• Law of Small Numbers: We overstate the significance of findings from small samples (e.g., chasing short-term "hot" fund performance or analyst calls).

Overconfidence bias. Experts, including financial analysts, are consistently overconfident in their predictions, especially in complex situations. This overconfidence is often inversely related to actual accuracy, leading them to rely on flawed forecasts and ignore contradictory evidence.

3. Conventional Forecasting Methods Are Fundamentally Flawed and Unreliable

Analysts’ estimates were sharply and consistently off the mark, even though they were made less than three months before the end of the quarter for which actual earnings were reported.

High error rates. Despite sophisticated tools and extensive data, analysts' earnings forecasts are notoriously inaccurate. Studies show average annual errors of around 40%, and less than 30% of quarterly estimates fall within a +/- 5% range of actual earnings. This level of imprecision renders detailed valuation models based on these forecasts unreliable.

Systematic biases. Forecasting is plagued by systematic biases, particularly overoptimism. Analysts tend to extrapolate past trends linearly and are slow to adjust estimates downward even when evidence suggests deterioration. Career pressures, such as pleasing sales forces and avoiding negative ratings that upset companies, also influence recommendations.

Inside vs. Outside View. Forecasters typically use the "inside view," focusing on the unique details of a specific company or situation. The "outside view," which relies on statistical probabilities from similar past cases, is far more likely to yield realistic estimates but is rarely used. This preference for the less reliable method contributes to persistent forecasting errors.

4. The Efficient Market Hypothesis Fails Because It Ignores Psychology

The error at the heart of EMH, we will see, is that it simply does not recognize that psychology plays a part in your investment decisions.

Flawed core assumption. EMH posits that markets are efficient because rational investors instantly and correctly process all available information, keeping prices at their intrinsic value. This assumption is contradicted by overwhelming evidence that human psychology (Affect, heuristics, overconfidence, overreaction) leads to systematic, predictable errors in judgment and decision-making.

Failure in crises. EMH failed to predict or explain major market crises like the 1987 crash, the LTCM collapse, and the 2007-2008 financial crisis. These events were characterized by irrational exuberance, panic selling, and severe mispricing, behaviors incompatible with the EMH model of rational actors and efficient price discovery.

Unsupported tenets. Key EMH tenets, such as volatility being the sole measure of risk and the immediate, correct adjustment of prices to new information, lack robust empirical support. Research shows no consistent correlation between volatility and return, and prices often adjust slowly or incorrectly to news, creating opportunities for informed investors.

5. Investor Overreaction Creates Consistent Opportunities in the Market

The investor overreaction hypothesis (IOH) states that investors overreact to certain events in a consistent and predictable manner.

Predictable mispricing. IOH posits that psychological biases cause investors to consistently overvalue favored stocks and undervalue out-of-favor stocks. This leads to predictable patterns of mispricing that persist over time, creating opportunities for investors who act contrary to the prevailing sentiment.

Earnings surprise effect. Earnings surprises act as "event triggers" that correct previous mispricings.

• Positive surprises significantly boost out-of-favor stocks (low P/E, P/CF, P/BV, high yield).
• Negative surprises significantly hurt favored stocks (high P/E, P/CF, P/BV, low yield).
• These effects are much larger than for "reinforcing events" (positive surprises on favored stocks or negative on out-of-favor stocks).

Regression to the mean. Over time, both overvalued favored stocks and undervalued out-of-favor stocks tend to regress towards their intrinsic value. This regression, often spurred by earnings surprises and other fundamental developments, results in the systematic underperformance of favored stocks and the outperformance of out-of-favor stocks.

6. Contrarian Value Strategies Systematically Outperform Favored Stocks

Value strategies work with a vengeance!

Empirical evidence. Decades of research consistently show that buying stocks that are out of favor, as measured by value metrics like low P/E, low price-to-cash flow, low price-to-book value, or high dividend yield, leads to significantly higher long-term returns than buying favored stocks. This outperformance holds across different market cycles and time periods.

Long-term advantage. Studies spanning over 40 years demonstrate the power of contrarian investing.

• Low P/E stocks have returned significantly more annually than high P/E stocks.
• Low P/BV and Low P/CF stocks also show substantial outperformance over their high-multiple counterparts.
• High-yield stocks, while trailing other value metrics, still outperform the market and low-yield stocks.

Downside protection. Contrarian value strategies also tend to perform better in down markets. Out-of-favor stocks typically decline less than the overall market and significantly less than favored stocks during bear periods, offering a degree of capital preservation.

7. Low Price-to-Earnings (P/E) is a Powerful, Proven Contrarian Strategy

The lowest P/Es beat the highest P/Es by 6.9 percent a year, almost doubling the annual return over this forty-one-year study.

Consistent outperformance. The low-P/E strategy, buying stocks with low price relative to their earnings, is the oldest and most documented contrarian approach. Studies show it has consistently delivered superior returns compared to the overall market and, especially, compared to high-P/E stocks over many decades, including recent turbulent periods.

Higher yield and appreciation. Contrary to conventional wisdom, low-P/E stocks often provide both higher dividend yields and better capital appreciation than high-P/E stocks. This combination of income and growth contributes significantly to their superior total returns over time.

Low turnover benefits. Holding low-P/E portfolios for several years without frequent trading still yields well-above-market returns. This buy-and-hold characteristic reduces transaction costs and taxes, further enhancing net returns compared to strategies requiring high turnover.

8. Low Price-to-Cash Flow (P/CF) and Price-to-Book Value (P/BV) Also Identify Winning Stocks

The similarity of results is remarkable.

Alternative value metrics. Beyond P/E, other value metrics like price-to-cash flow and price-to-book value also effectively identify out-of-favor stocks that deliver superior returns. These metrics capture different aspects of a company's value and can be used individually or in combination.

Strong performance. Studies show that stocks with low price-to-cash flow and low price-to-book value ratios significantly outperform the market and their high-multiple counterparts over long periods. Their performance is comparable to, though slightly less than, the low-P/E strategy.

Consistent patterns. Like low-P/E stocks, low P/CF and low P/BV stocks tend to offer higher dividends and better capital appreciation than favored stocks. They also demonstrate resilience in down markets and benefit from buy-and-hold strategies, reinforcing the broad applicability of the contrarian value approach.

9. High-Yield Stocks Offer Superior Returns and Downside Protection

High-yielding stocks outdistanced the market by 105 percent (all strategies include reinvested dividends).

Income and growth. While often seen primarily as income investments, high-yield stocks (those with high dividend payouts relative to their price) have also delivered above-average total returns over time. Although their capital appreciation may be lower than other value strategies, the consistent dividend income contributes significantly to overall performance.

Bear market resilience. High-yield stocks tend to perform particularly well in down markets, declining less than the overall market and other stock categories. The steady dividend income provides a cushion against price declines, making them a relatively safer option during turbulent periods.

Alternative to bonds. For investors seeking income, high-yield stocks can be a more attractive long-term option than bonds. Unlike fixed bond payments, dividends can grow over time, and stocks offer the potential for capital appreciation, which bonds typically do not.

10. Buying Unpopular Stocks Within Industries Provides Consistent Gains

Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group is.

Industry-relative value. Contrarian principles apply not just to the overall market but also within specific industries. Buying the cheapest stocks (by P/E, P/CF, P/BV, or yield) within a given industry, regardless of whether that industry is currently popular or unpopular, has proven to be a successful strategy.

Consistent outperformance. Studies show that the lowest-valued stocks within industries consistently outperform the highest-valued stocks within those same industries, as well as the overall market average. This suggests that the psychological tendency to overvalue favorites and undervalue laggards operates at the industry level as well.

Diversification benefits. This industry-relative approach allows investors to maintain diversification across various sectors while still applying contrarian principles. It provides exposure to potentially high-growth industries without necessarily buying the most expensive, potentially overvalued stocks within them.

11. Liquidity and Leverage Are Critical Risks Ignored by Traditional Theory

The combination of high leverage and enormous illiquidity almost wiped out the financial system.

Overlooked risks. Traditional risk theory (like CAPM) focuses almost exclusively on volatility, ignoring other critical factors like liquidity and leverage. These overlooked risks have played major roles in market crises throughout history, including the 1987 crash, the LTCM collapse, and the 2007-2008 financial crisis.

Liquidity dries up. Contrary to the EMH assumption that liquidity increases as prices fall, severe market downturns often see liquidity dry up dramatically. This lack of buyers exacerbates price declines, particularly for illiquid assets, turning minor corrections into panics.

Leverage amplifies losses. High leverage (borrowing to invest) magnifies both gains and losses. While tempting in rising markets, excessive leverage combined with illiquidity can lead to rapid, devastating capital loss and forced selling during downturns, as seen with financial institutions in 2008.

12. Inflation and Taxes Make Fixed Income Riskier Than Stocks Long-Term

Inflation and taxes sharply increase your risk in owning Treasuries, other bonds, and savings accounts over longer periods of time.

Inflation erodes purchasing power. Since World War II, inflation has become a significant risk, particularly for fixed-income investments like bonds and savings accounts. Over decades, inflation can severely erode the real value of principal and interest payments, leading to substantial losses in purchasing power.

Taxes compound the problem. Taxes on interest income further reduce the real return on fixed-income investments. For investors in higher tax brackets, the combined effect of inflation and taxes can result in a significant net loss of capital over time, making these seemingly safe assets surprisingly risky.

Stocks outperform long-term. Despite short-term volatility, stocks have consistently outperformed bonds and T-bills after accounting for inflation and taxes over long periods (5+ years). The probability of stocks preserving and growing purchasing power is far higher than for fixed income, making equities the less risky investment for long-term goals like retirement.

Last updated: May 18, 2025