Friday, August 29, 2008

The New Contrarian Investment Strategy: Chp 6: Avoiding Bad Market Odds

In this chapter, Dreman discusses investor biases and relates this to why the performance of investment professionals in general has been so poor. He references studies in psychological research to support his inferences.

Researchers have found that people often use mental shortcuts in calculating decisions in order to circumvent processing vasts amounts of inputs. Most mental shortcuts work well in everyday life but they consistently lead to incorrect calculations of investment probabilities. Investors need to be aware of this tendency.

Psychologists Amos and Tversky found that researchers tended to systematically overstate the importance of a small sample statistics despite their training in statistical methods. This bias is also present with investors who can be far too confident in their decisions armed with only a small number of supporting facts. The problem with using only a small number of facts is that it may not be representative of the real situation.

Another bias for investors is focusing too tightly on current information at the expense of looking at past outcomes for similar situations. Dreman uses the periodically hot IPO market as an example of this phenomenon. He refers to buyers, who in 1968 focused on individual IPO stories and forgot that 98 percent of them had dropped in price after the market break in 1962. Once again, in 1981, investors were frenzied to buy hot IPO issues and seemingly forgot the experiences that investors had with IPO's in 1968. Dreman's advice is to take into account the prior probabilities before making investment decisions.

Dreman discussed the concept of "regression to the mean" and how market participants seem to ignore this concept. In 1927 and 1928, investors thought (by their investment choices) that 35-40% returns were going to continue, despite the fact that those returns were sharply different from the long term market average. He comments that the belief that extreme returns will continue (either positive or negative) continues to exist in the market, despite the fact that this is out of line with what history has shown to be true. His advice is for investors to consider the longer term characteristics of stocks when current stock returns are abnormally high or low.

Another bias is believing that if a stock price is rising the stock is good and if the stock price is falling than the stock is bad. This bias comes from our intuitive belief that consistent inputs allows greater predictability. Dreman references Graham and Dodd who wrote "an inevitable rule of the market is that the prevalent theory of common stock valuations has developed in rather close conjunction with the change in the level of prices". Dreman's advice is not to expect immediate success with your investment strategy. If you expect immediate success, you are likely to get caught up trying to invest in "current fashionable" investments and fads.

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