Contrarian Investment Strategies Read online

  Appreciating the fundamental flaws in the investment strategies based on EMH will demand that we take a close look at one of the major sources of investment errors—the person you see in the mirror every morning. What psychology has to tell us about our investing behavior as individuals and within groups is, I think you will come to agree, both eye-opening and surprisingly useful in crafting an optimal investing strategy. Introducing a set of powerful psychological insights that help explain why investors so often make incorrect decisions and why the market is subject to so many booms and busts, it will provide ways to help us reject the siren call of many failed methods that are still the mainstay of contemporary investment practices; it will enable you to become a psychological investor. You will start looking at the “wacky” world of investing through a new sort of glasses: contrarian psychological shades (patent pending).

  Program for This Book

  I think readers would like to know at this point, in case you’re faintly worried, that a dry academic debate or dull scholarly treatise is not on tap. You can relax. I will present the research findings in an easily understandable manner, not with complicated mathematical equations.

  As you may already have noted, there are five parts in this book, each covering a major thematic area. Part I, “What State-of-the-Art Psychology Shows Us” looks at some of the most bizarre investment manias in history, crises that have helped us develop the new psychological insights into investors’ behavior. From sophisticated French nobles in the early eighteenth century to contemporary investment bankers (circa 2006) wearing sleek Zegna suits, nothing has held back people who believe that enormous wealth is within their grasp. Yet fascinating as these stories are, our purpose here is very different. We want to see how a historical perspective can be transformed into a psychological one that might be predictive of the characteristics of future bubbles and allow us to avoid jumping on the next bandwagon.

  Readers already conversant with psychology and stock market interactions will find some familiar themes and alarm bells in this work. But what is decidedly new for everyone is some recent psychological research that has pushed our understanding of investment strategies light-years ahead. Two new topics, Affect theory and neuroeconomics, are especially exciting to researchers, and neither has yet to be absorbed into Wall Street’s conceptual tool kit.

  The finding of how what is known as Affect works provides us with a powerful understanding of how people can so often be caught up in bubbles and come out almost penniless when they are over. Affect also works against investors in far more normal market conditions. We’ll examine its influence, how it was discovered through psychological research, and the role that its various corollaries have played in distorting “rational” market behavior.

  Then we’ll take up a number of other psychological pitfalls that are waiting to snare the unwary investor. It turns out, for example, that people simply aren’t very good statistical information processors, and that this deficiency leads them to make consistent and predictable investment errors. We’ll also discover that the more we like an investment, the less risk we think it entails even if it is riddled with risk, and that in some well-known scenarios we consistently misplay odds when they are heavily against us. We’ll also see how some aspects of psychology can continually trick us into buying securities that are red-hot just before they collapse and why so many of us continually play against bad odds.

  We’ll conclude by introducing two more heuristics (mental shortcuts), representativeness and availability, that cause systematic errors in our judgment. Both consistently take a good slice out of most investors’ portfolios. Throughout, we will see how psychologically compelling these mental shortcuts are and how hardwired into our minds they happen to be. But by learning to recognize them in action, we can fend off their all-too-tight mental embrace.

  In Part II, “The New Dark Ages,” a critical review of the efficient-market hypothesis will help you develop a precise understanding of why the most recent market crashes have proved so destructive and why the latest one has lasted so long.

  We will also deal with the efficient market’s sidekick, risk analysis. It states that if you want higher return, you must take higher risk, defined as volatility. Less volatility will give you lower returns. Yet this essential portfolio protection, which you’ve been told for years would keep your savings secure, doesn’t work and never did. We will also see that the risk evaluation methods employed today have failed miserably. The theory of risk that investors have depended on for decades to protect their portfolios is constructed on specious reasoning. Today we do not have a workable theory of risk to defend ourselves, nor have we had one in close to forty years. Small wonder that performance results have been so disappointing when bear markets come along. As will be detailed, this risk theory has been the chief culprit in the three shattering crashes since 1987 alone. We’ll see why and look at something better, a new, workable theory of risk, which is well documented and will take in many of the important risk factors we are faced with today, as well as some new and potentially devastating ones that are not yet incorporated into investment teachings.

  Along the way there are some hard lessons to be learned. For example, liquidity was completely sucked out of the system in 2008 and has only partially returned. We know that 60 percent of new jobs in the United States are created by companies with one hundred or fewer employees. Yet the banks, in spite of trillions of taxpayer dollars directly (and indirectly) funneled their way, have refused to lend to these job-creating firms. They couldn’t, as far too much of their excess capital was invested in illiquid subprime mortgages. And guess what academic thinking encouraged them to have such small liquidity reserves? Yes, the efficient-market theorists strike again.

  We’ll wrap up this section with a humorous but far too precise comparison of EMH to the ancient Ptolemaic theory of planetary motions, with efficient-market advocates playing the role of ancient astronomers loudly insisting, with lots of equations and highly advanced mathematics, that the sun absolutely has to orbit around the earth. There could be no other way.

  Part III, “Flawed Forecasting and Poor Investment Returns,” shows that despite the great confidence in forecasting, analysts’ forecasts through the years have been remarkably off the mark. Today’s analysts are expected to fine-tune earnings estimates within 3 percent of actual reported earnings to prevent damaging earnings torpedoes after an earnings surprise. The evidence in these chapters of large groups of analysts’ estimates over forty years demonstrates that earnings surprises are many times higher than the 3 percent analysts believe will not disrupt markets and are remarkably frequent.

  Further evidence indicates that even the smallest earnings surprise can have a major effect on stock prices. Most important, the research strongly demonstrates that surprises benefit contrarian stocks and damage favorite stocks over time, providing strong new evidence supporting the use of contrarian strategies. Despite the robustness of these findings, analysts and money managers ignore them. We must not make the same mistake.

  In Part IV, “Market Overreaction; The New Investment Paradigm,” I introduce the contrarian strategies that will allow you to account for these psychological foibles and forecasting errors, showing that these strategies have stood the test of time and also did well through the “lost decade” and the first ten years of the twenty-first century, outperforming the market and “favorite” stocks. (The returns, though positive, were naturally lower, given the two severe crashes during this time; but there was no total devastation or major loss of capital, as so many experienced.) When the bear roared loudly, the contrarian investors could stay the course with considerable confidence. We will take a close look, in particular, at how they fared through the dot-com bubble of 1996–2000 and the financial crisis of 2007–2008. The book will also fine-tune the strategies in light of the 2007–2008 crash by adding some further investment guidelines and safety features.

  A powerful hypothesis of investor behavior wi
ll also be presented, which explains why and how investors so often misvalue investments. It is called the investor overreaction hypothesis (IOH), and its thesis is that investors almost constantly overpay for stocks they like and just as consistently underpay for stocks they don’t. The IOH so far has twelve testable points, with more likely to be added as research continues.

  Part V, “The Challenges and Opportunities Ahead,” looks at what we should expect from markets in the next few years. We’ll also discuss the tools investors will need to handle the high-probability scenarios that will be described.

  Our tour d’horizon of this brave new financial world will touch on what is likely to come. We may be saying farewell to the “Great Recession,” but investors are a long way from exiting the perilous woods of inflation. As a forward-looking investor, you’ll want to be fully equipped and knowledgeable about the critical financial issues that could engulf us at practically any point in the future.

  The most important scenario is the major likelihood of serious inflation within two to five years, not only in the United States but also globally. We’ll consider the best investments that are likely to preserve your capital and even flourish in an inflationary environment. Also, we’ll review methods that investors in many other countries that have faced similar inflationary challenges have successfully followed to survive and prosper.

  A Personal Note

  You’re going to run across an occasional brief note on my private or professional experiences. Some of these notes I hope are amusing, and some are moments I’d definitely prefer not to repeat. I thought that in a work that’s so heavily indebted to the discipline of psychology, these personal reminiscences would lightly remind us that in the end we’re all only human.

  Sure, I’ve made more than a few investing choices I’d do over, and certainly not every single stock I’ve picked has come up a winner. I’ve had a few squirmy reminders that psychology affects me as much as the next guy. But as Warren Buffett once said, if a manager can bat .600 over time—get a hit six times out of ten—he or she will prove to be a big winner. In the end, fortunately, I was one of the few who outperformed the market over an extensive period of time.

  Ultimately, the most essential thing you can take away from the entire book is this: the psychology-aware investor holds a superior advantage, not just more theoretical knowledge but a genuine practical investing edge. I hope that’s an appealing reason to read on.

  Inevitably, not all market analysts will agree with my analysis. New ideas, even when they are strongly backed by empirical investment and psychological research, will not be accepted by most, because they contradict and threaten to dethrone the theory of the day. It doesn’t matter how good the new work proves to be or how badly the reigning ideas have failed; that’s irrelevant to the true believers, who will try to hold their turf to the last dollar that you have. That’s the way of paradigm change and probably has been since time immemorial. But fortunately the attacks are never on the reader; it’s the writer who is always called out.

  I have fielded criticism from academic and professional experts for more than thirty years, some of it containing sharp personal attacks. Nevertheless, though the fusillades may have sent a few of my feathers flying—not to mention on occasion raising my blood pressure to a frothy level—they have never been able to undermine the work.

  I believe that it is vital that we never underestimate the role psychology plays in the market. It can be our best friend if we follow the proven contrarian strategies that protect us so well against psychological traps. It can also be our worst enemy if we try to outguess the traps, for example, saying something like, “Okay, this market will blow, but I’ll just stay in a teeny bit longer” or “Heck, I’ve got my ten-bagger, I’ll sell at eleven.” Chances are those portfolios will end up at or near another financial Boot Hill. Psychology, no matter how much you’ve studied it or think you know it, can reduce both your ego and your net worth very quickly.

  David Dreman

  Aspen, Colorado

  September 30, 2011

  Part I

  What State-of-the-Art Psychology Shows Us

  Chapter 1

  Planet of the Bubbles

  DO YOU REMEMBER the days when investing was fun? I do. For me the late 1960s were a great time to be in New York City and in my midtwenties, just the right age. I started working as an analyst barely a year before the Go-Go Bubble developed. Anything we bought went up, not just 20 or 30 percent; hell, those didn’t even count, they were a waste of our capital. Computer service companies, health care, semiconductor stocks, and scads more shot up ten-, twenty-, even a hundredfold. We were all becoming wildly rich—or so my young colleagues and I cockily thought for the next eighteen months.

  We were a new generation, and this was a new market unlike any that had existed before. We laughed at the old fogies who bought blue-chip stocks and who shook a warning finger at us to sell before the bottom dropped out. Didn’t they realize this was only the beginning? More and more analysts were recommending these sizzlers, and all the hot mutual funds were piling into them as their funds soared. Once again, as in the distant 1920s, everyone was buying stocks. As they continued to move higher, our euphoria was endless.

  One of my friends (let’s call him Tim) was at that time in group therapy—he said to straighten himself out, but from our talks it seemed more likely that he wanted to meet new interesting women. Whatever the case, the red-hot market permeated the group. Tim, intelligent, articulate, and not in the least reluctant to express his views, quickly became the center of attention. The sessions, led by a psychoanalyst who was an avid investor himself, turned more and more into stock-picking seminars. One group participant, a diffident middle-aged businessman still under Daddy’s thumb, believed himself a financial failure. He bought one of Tim’s suggestions—Recognition Equipment—as the price doubled, doubled again, and doubled yet again. He was suddenly the ultimate business success, a multimillionaire. The transformation in his self-confidence was amazing, so much so that Tim now had trouble maintaining his position as the group guru.

  But the businessman’s newfound financial empire was not destined to last. Suddenly the market turned down sharply, and he was heavily margined. When Recognition Equipment began collapsing, the stock quickly led him to bankruptcy, whereupon Tim was made to return the Piaget watch he had been given in appreciation. At that point my friend turned to the First Avenue bar scene, which he hoped would provide better self-realization. Still, we all remained confident. The market drop was only a sharp correction, we were certain. The stocks we held, unlike those of other investors, were sound. And had to go higher . . .

  None of us escaped.

  Most of my friends lost all of their gains and much of their capital. As the markets screamed downward, I slowly remembered that I was a value analyst and got out with a modicum of my gains still intact, as well as what I thought was a newly acquired ulcer; it turned out to be just badly shaken nerves. But I had been taught a lesson. The ride up was magnificent, but the ending was horrific. Despite my training and knowledge of bubbles, I too was zapped.

  Though bubbles provide almost endless jubilation on the way up, the way down is like entering Dante’s eighth circle of Hell. And bubbles are not simply market aberrations, occurring only occasionally. No, they are far more integral to market behavior than that, as we shall see. They sharply magnify overreactions that occur in markets and work persistently against investors’ best interests. The dynamics of bubbles, and of the market reactions when they burst, have also stayed remarkably consistent over time. Unfortunately, we have not been good at learning from our mistakes.

  Consider this scenario.

  For almost two months the market continued to slide on increasing volume. The near-universal confidence that investors were simply beating through another correction in a market destined to move much higher was gradually changing into doubt. When rally after rally failed, that doubt turned to a deepening anxiety. C
ould something be very different this time?

  Next came the margin calls! Financial instruments at the heart of the nation’s growth and expansion plummeted for no apparent reason. Not just 2 or 3 percent but often 10 percent or more in a day. What was going on?

  Rumors were rampant that now one major institution and now another was on the brink of collapse. Something had to be done to stop the stampede that threatened to turn into a panic on a scale no one had ever seen before. The president, reluctant to interfere, was called on by his top advisers to make a statement that the economic outlook was sound and to assure the nation that major prosperity lay ahead after this brief hiccup.