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.
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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.