Contrarian and Factor Investing

Why this matters

This optional lesson covers ideas you'll meet in fund marketing and investing discussions: "be greedy when others are fearful," "smart beta," and "factor tilts." They rest on real research, but the research is more nuanced than the marketing, and some of it points in opposite directions depending on the time frame.

Contrarian investing

A contrarian buys what most investors are avoiding and is wary of what most are excited about. The idea is that crowds overreact: bad news pushes prices too low, and enthusiasm pushes them too high.

There's evidence that valuations matter over longer horizons. The 2013 Nobel Prize in economics recognized Robert Shiller's finding that stock prices fluctuate much more than dividends, and that the ratio of prices to dividends tends to fall when it's high and rise when it's low. The prize committee summarized the broader conclusion: there's no way to predict stock and bond prices over the next few days or weeks, but it's quite possible to foresee their broad course over longer periods, such as three to five years.¹

How it goes wrong: "too high" can get higher for years, and "too low" can be deserved. Being early is hard to tell apart from being wrong, which is why Part 6's Why Timing the Market Is Hard matters here.

Factors

The SEC describes a factor as a characteristic believed to cause certain types of securities to outperform or underperform the market as a whole, and gives value, dividends, and quality as common examples.² Some of the best-known research:

• Size and value. Fama and French's 1992 study found that company size and book-to-market equity captured much of the variation in average US stock returns, with smaller and cheaper stocks earning higher average returns over the period they studied.³
• Momentum. In 1993, Narasimhan Jegadeesh and Sheridan Titman documented that strategies buying stocks that had performed well and selling those that had performed poorly generated significant positive returns over three- to twelve-month holding periods, though part of those returns faded over the following two years.⁴

The rest of this lesson is for members

Still to come in this lesson: Why the findings seem to conflict, Factor funds, the key takeaways, and 2 quiz questions with explanations.

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