Human psychology dictates that we follow the herd to minimise dangers. This is where things can go wrong in equity investments through stock market. Here is where contrarian investing in equity can help in beating the odds and aid wealth creation if done right. Let us see how.
How investor psychology works in stock markets
There are two aspects of the human mind that work against the interests of an investor. The first is the tendency to find safety in numbers. This is often at the cost of independent analysis and conclusions with respect to market movements and the underlying reasons. This phenomenon is known as the ‘herd mentality’. This forces investors to buy when others are rushing to buy, and sell when others are selling in droves. The fundamental assumption here in such investors’ minds is that the market must know what it is doing and that the consensus opinion cannot be wrong.
Sometimes, herd mentality can also manifest as ‘Fear Of Missing Out’, or FOMO. That is, investors may panic when they see everyone buying a particular stock or fund, and conclude that it must be a good deal that cannot be missed out on. Similarly, when everyone else is selling, a fear may set in that everyone is cashing out profitably.
The second aspect is that we are creatures of habit. Investors may find comfort in extrapolating current patterns of market movement into the future as well. When markets are rising, investors tend to assume that they will keep rising in the foreseeable future. Similarly, they expect falling markets to never recover.
What is contrarian investing
Contrarian investors tend to hold an opinion that is contrary to the general consensus in the market. They are bullish when markets are bearish, and vice versa. They do not succumb to herd mentality, nor are they given to believing that the past is an indicator of the future as far as market movements go, at least in the short term.
However, contrarian investors understand very well the cyclical nature of, as well as the long term potential of, asset appreciation in the stock markets. Contrarian investing involves taking advantage of opportunities missed by the herd. It involves taking an opposite viewpoint or hypothesis with respect to the market and in-depth research to either prove or disprove their hypothesis. If proven correct, contrarian investors end up outperforming the market.
Using contrarian techniques for wealth creation
Contrarian investors are usually ahead of the curve when they get it right. They are able to spot downturns much before the herd and book profits, minimising potential losses later. Conversely, they see opportunity to buy when stock markets have slumped, thus realising high capital gains later when markets do rise.Investors can also take the mutual fund route if they are not able to do this on their own. Contra funds and value funds become the investment products of choice in that case.
Since contrarian investing strategy requires sufficient time to play out, adopt it only if you are patient enough to see it through. You must be prepared to take on some risks, especially in the initial phases of your investment timeline, when your hypothesis has not yet been proven or disproven.
This article was originally published in The Financial Express
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