The stock market has experienced booms and busts throughout its history. Neither have prevailed over the long run. However, when we are in the midst of either, investors are often lulled into thinking they will last forever.
Indeed, during the 2020 bear market, many investors believed it would be far worse and more prolonged than proved to be the case. It ultimately lasted less than three months and the FTSE 100 declined by a relatively modest 32pc.
Similarly, investor sentiment was exceptionally downbeat during the global financial crisis. Doomsday scenarios that included the end of the global financial system and even a return to barter gained traction among investors.
Yet it was followed by an 11‑year bull market that produced record stock market highs. Investor sentiment can equally be influenced by a rising stock market.
For instance, valuations reached fever pitch last year as the investment “herd” believed that the low interest rates that helped to produce sky-high stock valuations would last forever.
Clearly, it is very easy to get caught up with the consensus view during both bull markets and bear markets.
However, investors who can ignore market sentiment in favour of cold, hard facts could use the stock market’s boom/bust cycle to their advantage by purchasing shares when other investors are downbeat and selling them when others are in an ebullient state of mind.
Cynics will argue that a contrarian investment strategy is obvious. Indeed it is. It simply entails using the overreaction of investors to buy shares when they are priced at levels that significantly undervalue their future prospects and sell them when the opposite is true.
The challenge with such a strategy lies in its execution. It is incredibly difficult for any investor to ignore the views of their peers – whether bullish or bearish – and invest solely on the basis of facts and figures. However, it is possible for investors who are disciplined and have a long time horizon.
Discipline is required to rely solely on company fundamentals when deciding whether to buy or sell shares. For example, if an investor unearths a business with a solid balance sheet, a clear competitive advantage and a low valuation by historical standards, they should back their judgment and buy it irrespective of consensus views.
Likewise, they should sell shares that seem overvalued even if other investors are upbeat about them.
A long‑term outlook is needed to implement a contrarian strategy because it can take time to pay off. For instance, buying shares during a bear market can produce paper losses in the short run because investor sentiment may weaken before it improves.
Similarly, stock markets can rise beyond justifiable levels during a bull market. Investors who sell shares may need to be patient before buying back into the market.
However, the vast majority of investors do have a long time horizon. In most cases they are investing for retirement or other long‑term goals. They can therefore afford to look beyond short‑term market movements when implementing a contrarian strategy.
Of course, no investor should be a contrarian for the sake of it. They should not simply buy the most unpopular or worst‑performing stocks they can find.
Investing should always start and end with an assessment of the company in question. The key to success is in not allowing the views of others to affect your own investment decisions.
As with any investment strategy, mistakes will be made. Assessing the quality of a company and its value is highly subjective.
The key point, though, is that the investment “herd” is nearly always wrong in the long run. It frequently overestimates how deep and how long a bear market will be. It also believes that every bull market will continue unabated because it is “different this time”.
Ultimately, bull markets and bear markets follow each other as part of a cycle. Investors who are willing to go against the consensus view are far more likely to capitalise on it to generate high returns over the long run.
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