Contrarian Investing Versus

 In Investments

Some people advise stock market investors to be contrarians: buy low and sell high. That is, you should put your money into market sectors that are out of favor. Those stocks are likely to ride the next leg of the business cycle and ultimately enable you to sell at a profit. Such a strategy, applied to the broad stock market, would have paid off in 1982. In that year the Dow Jones Industrial Average dipped below 777, from a previous high of 1050, before increasing to more than 11,700 in 2000.

Other investors advocate a momentum- based approach: look for stocks or industries that are gaining favor, as shown by rising prices, then ride that wave of investor enthusiasm before it wanes. A canny investor could have spotted the spread of the Internet in the mid- 1990s, prospered in the dot-com boom of the next few years, and then taken profits when technology stocks relinquished market leadership. Can either of these methods work in this century’s investment environment? You might weigh them by looking at recent results among so-called “sector” mutual funds. These funds invest solely or primarily in companies within a particular industry, such as real estate or health care.

Counting on comebacks
Morningstar lists nine categories of specialty stock funds. In 2004, a contrarian investor might have invested in a precious metals mutual fund. While the Standard & Poor’s 500 Index returned nearly 11% that year, precious metals funds (which mainly own stocks of gold mining companies) lost more than 8%, on average. In hindsight, that would have been an ideal time to buy a precious metals fund. Such funds returned over 30% in 2005 and have continued to gleam as the price of gold has soared. Through August 2011, the average precious metals fund had an annualized return over 13% a year for the past five years, the best of all Morningstar categories.

In 2004, technology funds were the second worst performers, returning only 4.2%. Those funds have not done as well as precious metals funds. If you had invested then, you would have seen tech funds fall to last place among sector funds in 2005 and finish next- to-last in 2006. Tech fund investors didn’t see a substantial payoff until 2009, when the category returned 62%.
Similarly, contrarians might have bought financial services funds (which largely own bank stocks) and real estate funds in 2007. Both categories suffered double-digit losses while the broad market had positive returns. As we’ve seen, though, troubled financial institutions and collapsing real estate values led the market down in the crash of 2008 and have yet to recover. Financial funds, in fact, are showing steep annualized losses for the past three and five years.

Going with the flow If the results for contrarian investors have been mixed, how have momentum investors fared? In 2004, when contrarians might have been buying precious metals and tech funds, momentum investors may have put money into equity energy funds (up 33%) or real estate (32%). Real estate funds had two more good years, in 2005 and 2006, then suffered in 2007 and 2008. Altogether, real estate funds had a negative return, on average, for the five years through August 2011.

What about equity energy funds, which own stocks of oil companies and of other companies in related industries, such as well services? These funds tend to ebb and flow with the price of oil. They’ve generally been strong in the past decade, with oil prices much higher than they were in 2001. Savvy investors might have made money in the past few years, especially if they managed to sell last May, when the price topped $110 a barrel. However, fear of an economic slowdown caused this category to lose nearly 11% in August 2011, and recession worries could continue to deplete past profits. Precious metals fund investors could have benefitted from momentum investing in 2010, when that category set the pace, but the price of gold has soared so rapidly that further growth may be difficult to sustain.

Drawing conclusions Both the contrarian and the momentum styles of investing have produced positive results in some instances, so you may want to incorporate these concepts into your investment planning. However, there is no simple way to achieve investment success.