Week 36 Day 5: Contrarian Investing: The Lonely Path That Pays

In March 2009, the S&P 500 had dropped 57% from its peak. The headlines screamed: 'Is this the end of capitalism?' Nobody wanted to buy stocks. Warren Buffett wrote an op-ed: 'Buy American. I am.' Those who followed his advice earned 400%+ over the next decade. Being contrarian when everyone is panicking is the highest-return strategy available -- and the hardest to execute.

Contrarian investing in practice: (1) Buy during crashes. The best single days to invest are the days that feel the worst. The 10 best investing days in any decade almost always occur within 2 weeks of the 10 worst days. If you buy VTI monthly via automatic contributions, you naturally buy more shares when prices are low (crashes) and fewer when prices are high (peaks). DCA is automatic contrarianism. (2) Do not sell during crashes. From 2007-2009, the S&P 500 fell 57%. By 2013, it had fully recovered. Investors who held earned those gains. Investors who sold at the bottom in 2009 locked in the loss permanently. (3) Resist euphoria. When your Uber driver is giving stock tips (1999), when your hair stylist is flipping houses (2006), and when your teenager is explaining NFTs to you (2021) -- it is time for caution, not excitement. (4) Rebalance into the unloved. When stocks crash and bonds hold steady, your portfolio shifts from 80/20 to 65/35. Rebalancing means selling stable bonds and buying crashed stocks -- a profoundly contrarian act that improves returns by approximately 0.5% per year. Why contrarianism works but is rare: it requires acting against your survival instincts. In nature, running away from what everyone else is running from is how you survive. In markets, running toward what everyone is running from is how you profit. The two instincts are directly opposed.

The contrarian premium is empirically well-established: De Bondt and Thaler (1985, 1987) showed that past losers (stocks with the worst 3-year returns) outperform past winners (stocks with the best 3-year returns) by approximately 8% per year over the subsequent 3 years. Lakonishok, Shleifer, and Vishny (1994) showed that value stocks (low price relative to earnings, book value, or cash flow -- essentially contrarian stocks that the market has 'given up on') outperform glamour stocks (high price relative to fundamentals -- the crowd favorites) by approximately 5-8% annually. The mechanism: herding and momentum push popular stocks above fair value and unpopular stocks below fair value. The eventual mean-reversion generates the contrarian premium. However, contrarian investing at the individual stock level is high-risk: not all beaten-down stocks recover (some go to zero). The safe form of contrarianism is at the asset-class level: rebalancing from appreciated assets to depreciated assets (e.g., selling bonds to buy stocks after a crash). Ilmanen (2011) demonstrated that this 'rebalancing premium' is approximately 0.5-1.0% per year for a 60/40 portfolio and increases during high-volatility periods. The psychological mechanism behind the contrarian premium is prospect theory: loss-averse investors dump losing assets too aggressively during panics (fear of further loss) and herd into winning assets too aggressively during booms (desire to participate in gains), creating systematic mispricing at extremes that contrarian strategies exploit.