From a low of 12316.10 on March 16 this year, the BSE sensex quickly clambered up to 15868.85 on July 24, reflecting a gain of almost 29 per cent in a little over three months. Then the market tanked — 541 points, or 3.43 per cent — on Friday.

The wild roller coaster ride is what makes the stock markets so exhilarating and scary at the same time. The fluctuations also give investors the opportunity to make a little pile of cash — if they can time their entry and exit from stocks.

But the question that confronts every investor is this: should you be chasing the herd or going against the flow?

The herd mentality leads to stocks trading at a much higher price than their intrinsic value during upswings. The stretched valuations sooner than later result in a sharp fall in stock prices. Once stock prices start declining, the herd mentality comes into play and an all-round selling of shares pushes share prices further down.

A contrarian investor, on the other hand, invests in stocks that are fundamentally sound but ignored by the crowd for some reason or the other and then waits for the herd to discover those stocks and push up their prices.

“A contrarian approach is particularly beneficial during the boom periods when the broad market becomes overvalued,” says a fund manager with SBI Mutual Fund.

Turn to the mutual funds and you will understand the concept better. SBI Mutual Fund floated its Magnum Contra Fund in 1999 when the stock markets were riding a crest. Kotak Mutual Fund and Tata Mutual Fund came out with their contra schemes in July and October 2005, respectively. In June 2005, the sensex crossed the 7000-mark. Then came DBS Chola and UTI Mutual Funds with their contra offerings in February and March last year when the sensex crossed and settled above the magic mark of 10000. As the market continued to roar past 14000 in February this year, Lotus India Mutual Fund thought the opportunity just ripe to launch its contra scheme. And of now, JM Financial Mutual Fund is offering its plan as the sensex starts to prepare for its tryst with 16000.

Why do mutual funds launch their contra schemes when stock markets reach a crest? Is it the best strategy to adopt a contrarian approach when the markets approach a new high?

“The higher the prices rise, more the people want to buy. Investors tend to follow trends and short-term events. This creates contra opportunities,” says R. Rajagopal, fund manager at DBS Chola Contra Fund. However, he adds that contra opportunities could be found in every market situation.

When and where do contrarian opportunities arise?

1. Investors often ignore or discard a particular stock or sector following negative short-term news in the stock or the sector. For example, the Infosys stock lost 37 per cent in two days of trading in May 2003 on a low guidance from the company. The stock fell from Rs 1,032 to Rs 650 giving rise to a contra opportunity.

2. Low expectation of short-term growth of a particular stock or sector often leads to undervaluation of good companies by investors at large. For example, the reports of under-recoveries of petroleum product prices by oil marketing companies played havoc on stock prices of BPCL and HPCL between February and August 2005. While the sensex surged steadily, the share prices of BPCL and HPCL went downhill.

3. Stocks or sectors not discovered by investors. Pantaloon Retail is an example. The potential of the retail sector was not fully comprehended by investors because of which the Pantaloon stock was trading at Rs 200 till December 2003. The stock price reached Rs 2,378 in December last year.

However, take a look at the returns of existing contra funds. Except for SBI Magnum Contra Fund and Kotak Contra Fund, others have failed to match the sensex returns during the year ended June 2007. During the period, the sensex yielded a return of 38.09 per cent, while Magnum Contra gave a return of 61.05 per cent and Kotak Contra 49.25 per cent.

“Contra funds are long-term investments as it generally takes at least 24 months to realise the full potential of a contra stock,” says Sanjay Sinha of SBI Mutual Fund.

If you want to take up the contra investments on your own without doing it via mutual funds, look at the investment portfolios of contra schemes of mutual funds (see table) and you will be able to understand the sectors where the mutual fund managers are currently taking a contrarian view.

The table shows that energy, technology and consumer non-durables are the sectors where most of these mutual funds are investing a larger part of their assets under their contra schemes.