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The Short Answer

How to Be a Contrarian Without Getting Burned

These three tips can help you successfully buy what others are selling.

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Question: I know that some of the most famous investors have been contrarians. But what exactly does that mean, and how do I implement the approach in my portfolio?

Answer: As harrowing as the recent market sell-off has been, widespread pessimism surrounding the economy has been creating opportunities for valuation-conscious investors. For much of the year, Morningstar's equity analysts had considered stocks in their coverage universe to be slightly overvalued. But as a result of the harsh sell-off in the last week, the average stock in our coverage universe is now trading at a more than a 10% discount to fair value, and our analysts think high-quality names such as  Abbott Laboratories (ABT) and  ExxonMobil (XOM) appear to be quite cheap.

Picking up mispriced stocks is a contrarian investor's objective, and such opportunities invariably surface when the market is looking particularly weak. Being willing to purchase out-of-favor stocks, then selling them after their share prices have recovered, can obviously lead to above-average gains. On the other hand, avoiding companies where there is excessive optimism about a stock or sector can help the contrarian avoid market bubbles like the late 1990s technology heyday and the Nifty Fifty era of the 1970s.

As lucrative as a contrarian strategy might seem, executing isn't exactly straightforward. Here are three pointers for going against the crowd without getting trampled.

Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.