As per my understanding, an investor can earn a return primarily in two ways. First, to follow the market. And the other, stand against the market.
What do I mean by following the market?
It means following a trend. As far as the investor can be in the direction of the market at an early stage of the trend and leaves the market before the trend ends, the investor stands to gain. Unfortunately, retail investors join the trend towards the end of the cycle.
It may sound very easy that you can follow the trend and earn well. But to do this consistently is not easy.
The other way to make money is to invest by being a contrarian investor.
What does being a contrarian mean?
Well, it means standing against the market. In simple terms, the investor thinks that the market is behaving irrationally and takes a position which is contrary to the trend of the market.
Again, it is not easy to be a contrarian investor. Financial analysis can indicate a lot of great opportunities but to stand against the market is psychologically not easy. It is with the hope that in due course market will realise and the share price will bounce back.
How can a retail investor benefit from following the market?
Often magazines and newspapers are filled with charts and buy/sell recommendations. It is a poor level of research and should not be acted upon.
A relatively easier way to follow the market is to invest alongside a broad market index. An investor can simply invest in ETFs or index funds. This way the return of the market with the return of the investor.
Another option to be with the trend is to allocate funds in 4 to 5 mutual funds across large-cap, midcaps, and small-cap. The reason I say mutual funds are also following the market is primarily because most of the mutual funds will have large number of stocks ranging between 30 to 40 stocks. Running a contrarian position within a mutual fund may not be easy.
This is precisely the reason when the markets fall, mutual funds also fall, and when the market rises, mutual funds also rise. One of the ways to identify a good mutual fund is to observe mutual fund performance during a falling market trend. A mutual fund holding quality businesses will fall less than the market.
Now the more complex option i.e. being a contrarian investor. If you want to dig deeper into this approach, there is a very good book written by David Dreman, Contrarian Investment Strategies: The Psychological Edge. The book explains the benefits of being a contrarian investor and how to evaluate such opportunities.
There are many contrarian ways, but I will restrict myself to less risky ones. Identify quality companies that is companies generating high returns on capital over a long period say 10 years plus, have low or no debt and currently going through some tough times. These tough times could be qualified as temporary issues related to any product, some notice by a regulator, a bad quarter, industry headwinds, et cetera. The key is to dig deeper into the company and figure out whether the problem is temporary or permanent. Usually, problems are permanent if they are related to bad capital allocation decisions that is acquisition or unethical practices by management.
The reason contrarian investors make money over due course is because the price at which they enter is low. In case there is negative news against the company, often the price is smashed by the market. Hence, a great opportunity for investors to get in.
However, it is not an easy task. There are a lot of psychological hindrances. One of the ways of addressing psychological issues is to dig deeper into the company and understand the issues from a variety of angles. What this means is rather than looking only from a financial sense, you should be able to look at a problem from a variety of perspectives. On one hand, no degree can teach you this and on the other hand diverse reading can help you build this understanding.
Different investors can have different ways whether to be a contrarian or be with the trend. However, the idea is to be aware of what kind of investor you are. Often, I see people claiming themselves to be long-term investors, but they are focused on daily price moves.
It is better to be emotionless when it comes to investing whether you follow the trend or you don’t. There is a lot of humbleness that great investors have and that primarily comes from acknowledging that even with the best of effort they still need a lot of luck.
I hope your investment journey is filled with a lot of learning and a lot of luck.
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