Saturday, July 24, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 17

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.

In this the final chapter of the book, Dreman takes one last look at the Efficient Market Hypothesis (EMH) and notes its flaws for the reader. When considering the data that is often cited to provide evidence for EMH, readers should remember that correlation is not causation. In many studies, correlation is often shown, and causation is often assumed. To demonstrate this, Dreman discusses how, throughout the last several decades, skirt hemlines and Superbowl champions have correlated well with certain stock market returns, but that no serious investor would believe in a causal relationship.

The assumption that each individual investor behaves rationally is also a huge leap. Since investors have different goals, differing amounts of knowledge, and various opinions on how to interpret all the data that is available, an assumption that all investors behave in the same way is not practical.

Moreoever, Dreman takes apart the conclusions that were reached by various studies that are often cited by EMH proponents. For example, a study showing that stocks post-split show no excess returns is often used to show that markets are efficient. But Dreman digs into the data and finds that the researchers used the date of the split to measure post-split returns rather than the date of the split's announcement, which biases the results.

Other studies that show the market reacts immediately to earnings news or merger announcements are also used as evidence to show that markets are efficient. Dreman scoffs at this, noting that all the studies show is that markets react, not that they react correctly.

But the best argument against EMH in Dreman's opinion is the fact that there are several systematic methods to beat the market (including the low P/E, low P/B methods described in previous chapters). But the scientific paradigm that is EMH is so ingrained in academia that it continues to ignore the evidence against it. Until there is a new paradigm that can better explain stock market returns, Dreman doubts EMH will be abandoned. In the interim, those who employ contrarian approaches are afforded the opportunity to generate abnormally high returns.

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