- Out-of-favor securities may be undervalued, popular securities almost never are.
- What the herd is buying is, by definition, in favor.
- Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked.
If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring.
- When the herd is selling a security, the market price may fall well beyond reason.
- Ignored, obscure, or newly created securities may similarly be or become undervalued.
- Since they are acting against the crowd, contrarians are almost always initially wrong and likely to suffer paper losses. By contrast, members of the herd are nearly always right for a period.
- Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.
Holding a contrary opinion is not always useful to investors, however.
- When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome.
- By contrast, when majority opinion does affect the outcome or the odds , contrary opinion can be put to use.
- When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor.
- When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.