Saturday, July 3, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 10

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman discusses some of the psychological effects that cause investors to stray from investing styles that the data shows beat the markets. For one thing, investors fall victim to the representativeness heuristic that causes them to see similarities in situations which are otherwise different. For example, a particular event (e.g. a recession) may have followed a market movement of what sort, and therefore the investor will interpret a repeat of that market movement to signify that another recession is on the way. Dreman encourages the reader to look beyond superficial similarities in market occurrences to avoid falling into this trap.

Another problem that causes investors to lose their way is their over-reliance on data taken from small sample sets. Investors follow a few famous market "gurus" after they make a few correct calls, when in all likelihood, with so many people making calls, there were bound to be some correct ones. Investors should look at a money manager's track record over several years (e.g. using a budget calculator), and not be convinced of the fact that a manager has superior investor prowess on the basis of a few correct calls or a couple of strong years.

One concept that humans do not incorporate very well into their decisions is regression to the mean. Tall people tend to have children shorter than they are, and short people tend to have children who are taller than they are; this is known as regression to the mean. All to often, people get caught up in the recent market movements and assume these will occur forever. But Dreman argues that high stock returns now means lower (not higher) stock returns later, as stock returns overall will regress to the historical mean.

No comments: