Consensus Theory and Contrarian Investing

by KenFaulkenberry

in Value

Consensus Theory and Contrarian Investing

Consensus Theory and Contrarian investing

Contrarian investing can used in investment analysis to increase the probability of a favorable outcome. In this post we will explore how the value investor can use consensus theory and contrarian investing to take advantage of mis-priced assets.

What is Consensus Theory in Investing?

In investing consensus theory there is general and widespread agreement in the investment community. This agreement could be about the prospects for a particular individual investment, industry, sector, asset class, or even a particular investment strategy.

When the vast majority of people are in agreement a community is vested in maintaining the status quo. This reaction causes the majority to shut out different ideas and close their minds to anything that conflicts with the consensus.

This “group thinking” becomes a universal mindset, and in consensus theory, can reject all conflicting views. This leads to critical points where a value investor should look for opportunities in under priced assets and avoid the risks of over priced assets.

What is Contrarian Investing?

A contrarian is someone who attempts to use consensus theory to recognize when conventional opinion is wrong. Contrarian investing is a form of value investing and attempts to buy and sell assets that are mis-priced due to consensus buying or selling of an asset. A contrarian investor needs to think ahead of the crowd.

Recommended Reading:  Mr. Market and the Intelligent Investor

Thinking ahead of the crowd often means thinking the opposite or contrary to what the vast majority believe. Following the herd can be destructive to a portfolio.  If investors reach a consensus and have a particular outlook on an asset, the current price already reflects that outlook.

In other words, if 90% of investors believe an asset is going higher they have probably already bought; leaving few buyers to drive the price higher. Conversely, if 90% of investors believe an asset can only go lower they have most likely already sold; leaving few sellers to drive the price lower. In both cases, it takes very little to spark a major change in direction, leaving the majority fully invested at tops, and under invested at bottoms.

Consensus Theory and Contrarian Investing

The value investor can use consensus theory and contrarian investing as another tool in looking at valuation. Don’t let the culture and the crowd draw you into group thinking. Just because the majority are in agreement doesn’t make it true.

Related Reading:  Perceived Risk vs. Real Risk: A Key to Successful Value Investing

Investment Decisions Should Be Based On Valuation


Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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{ 2 comments }

Don

Thanks Ken,

Great article – that really explains the Apple price drop. Everybody loved it and there was no one left to buy after 80% of the market owned it. It had to go down once people began to figure this out.

KenFaulkenberry

Great example Don! Thanks.

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