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Core of the Story

By their very nature, contrarians come in all forms. Some draw on investor psychology to make their judgments and others rely on their instincts. They all agree that the stocks that have gone down the most over the recent past are often the best investments. At the risk of oversimplifying the arguments used by contrarians, here are two:

  • It is always darkest before dawn. The best time to buy a stock is not when good news comes out about it but after a spate of bad news has pushed the price down, making it a bargain. The story rests on the assumption that the average investor tends to overreact to news—good as well as bad—and that investors who are a little less driven by emotion (presumably you and I, as contrarians) can take advantage of this irrationality. The story sells well, at least in the abstract, to those who have the least faith in human rationality. The assumption that investors overreact ties in neatly with the widely held view that crowds are driven by emotion and can be swayed by peer pressure to irrational acts. This view is reinforced in financial markets by the bubbles in prices—from the South Sea Bubble in the 1600s to dot-com companies in the 1990s—that show up at regular intervals.

  • Lower-priced stocks are cheaper. There is another and less rational factor behind the contrarian story. Stocks that have gone down a lot often trade at low prices, and there is a feeling among some investors that a lower-priced stock is cheaper than one that is highly priced. Thus, a stock that has dropped from $30 to $3 looks cheaper on an absolute basis to many investors and penny stocks (stocks that trade at well below a dollar) are absolute bargains. The danger, of course, is that the value of this stock (which is what you should be comparing the price to) might have dropped from $35 to $1 during the same period.


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