Wednesday, August 27, 2008

The New Contrarian Investment Strategy: Chp 5: The Not-So-Expert Expert

Analysing stocks with fundamental analysis requires configural (interactive) processing, where the impact of one piece of information on other inputs needs to be considered and weighed for impact. For example, a companies competitive environment may affect how an analyst views the impact of growth rates. The successful investor needs to process an exponential number of diverse interactive factors which taken together affect the overall valuation.

Dreman references clinical psychological tests that convincingly demonstrate that humans are not efficient processors of interactive inputs. Rather, humans are very competent and reliable in processing information linearly and with a defined sequence of steps.

In light of the studies, Dreman asks the question of how dependable are the methods employed by analysts? The amount of information they need to process is vast. In addition, different weights need to be applied to the factors depending on the judgement of the analyst. Dreman observes that Wall Street pays close attention to security analysts reports. The inferior investment results by professionals largely based on this research was noted in the first chapter of this book. Dreman comments that in-depth information does not mean in-depth profits

Dreman collected 52 samples of expert forecasts of favorite stocks and industries from 1929 to 1980 and found that 77% of the professional surveys underperformed the market. The implication is that you would be better off by randomly selecting stocks than following professional advice. Dreman references many more examples that support the idea of systematic forces working against investment professionals. In the next few chapters Dreman will examine these systematic forces and how to counter them.

Dreman foreshadows a more effective approach to security analysis by quoting Garfield Drew from an earlier era (1941) "In fact, simplicity or singleness of approach is a greatly underestimated factor of market success. As soon as the attempt is made to watch a multiplicity of factors even though each has some element to justify it, one is only too likely to become lost in a maze of contradictory implications ..."

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