Aswath Damodaran: Dangers of Contrarian Investing

In his recent blog post NYU professor Aswath Damodaran examines the popular investment advice to “buy the dip” – that is, to purchase stocks or markets after sharp declines.

He explores the various forms of contrarian investing, the historical evidence supporting and challenging these strategies, and the psychological demands required to succeed as a contrarian investor. Aswath urges investors to approach contrarian strategies with caution, discipline, and self-awareness, rather than simply following the crowd or relying on historical averages.

Here are the key takeaways:

• Contrarian investing comes in different forms: Aswath outlines four main types-knee-jerk contrarianism (buying any asset after a sharp fall), technical contrarianism (buying only when technical indicators suggest a bottom), constrained contrarianism (buying beaten-down stocks that also meet quality and safety screens), and opportunistic contrarianism (using market declines to buy high-quality companies that were previously too expensive).

• Evidence for “buying the dip” is mixed: While long-term data shows that equities tend to recover and outperform other asset classes, Aswath warns of selection bias and long recovery periods after major downturns. Not all declines are followed by rebounds, especially if rooted in fundamental problems.

• Risks of blindly buying the dip: Aswath cautions that buying after a drop can be like “catching a falling knife.” Market declines may signal deeper issues, and some stocks or sectors may never recover. Investors risk significant losses if they do not carefully assess the reasons behind the sell-off

• Psychological demands are high: Successful contrarian investing requires a unique mindset, patience for potentially long recovery periods, and the emotional resilience to withstand further declines after buying. Aswath emphasizes that not everyone is suited for this approach, especially those easily swayed by market sentiment or peer pressure.

• Screening and valuation matter: Aswath recommends that contrarians use quality and valuation screens to avoid value traps-stocks that are cheap for good reason. Opportunistic contrarians should re-evaluate companies after a market drop, adjusting for new risks and cash flow expectations before buying.