Making contrarian investing work

Performance tends to persist in the short run, but betting on long-term losers can be a winning strategy.

Alex Bryan 21 October, 2014 | 6:00PM

I have always admired contrarians. It isn't easy to think and act independently. Clients evaluate professional managers' performance against a benchmark, often over short windows. Those who underperform for a few years risk losing their clients, even if their investments ultimately pay off. That makes it difficult for many managers to make bold bets. Investing mistakes may also be easier to swallow when everyone is in the same boat. There is comfort in conformity, but this innate social desire can create opportunities for those who have the courage to think independently.

Fear and greed may create herding behaviour. Investors tend to chase performance, buying securities that have recently done well and selling those with poor performance. This may partially explain the short-term persistence in asset returns, known as momentum. Generally, assets that have outperformed over the past six to 12 months continue to outperform over the next several months, while those that have underperformed continue to do so. That might suggest that a contrarian strategy wouldn't work well. Indeed, trading against momentum has historically been a losing strategy.

Yet, short-term momentum may push asset prices away from their fair values, leading to long-term reversals in asset returns, which is associated with the value effect. Assets with poor returns over long horizons eventually become cheap, and as a result, may offer better returns going forward. In a study published in 1985, De Bondt and Thaler found that stocks with the worst returns over the previous three to five years outperformed those with the best prior returns over the next three to five years. (However, a disproportionate portion of this outperformance occurred in January.) While this is a fairly crude approach to value investing, it illustrates that investors should fight the urge to extrapolate past performance into the future. Often, assets with dismal past performance offer the best opportunities.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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