Contrarian Investment Strategies

by David Dreman

  20. Tversky and Kahneman, “Belief in the Law of Small Numbers.”

  21. Tversky and Kahneman, “Judgment Under Uncertainty: Heuristics and Biases,” pp. 1125–1126; Tversky and Kahneman, “Intuitive Predictions,” pp. 313–327.

  22. Looking back briefly to “Judgments of Risk and Benefit Are Negatively Correlated,” on page 39, again we see this important psychological discovery played out clearly in the market. Investors believed not only that the dazzling performance of stocks during the bubble would provide better returns but that these stocks would prove to be less risky than the far safer but less exciting stocks in the S&P 500. The psychologists’ results in chapter 2 were thus dead-on. Neither investor assumption was correct: higher-performing stocks were not less but more risky than the far safer stocks in the S&P 500. Too, the S&P 500 didn’t go down nearly as much as the “hot hand” stocks after the market’s terrifying break. The S&P 500 also outperformed the “hot hand” stocks by a good margin over time.

  23. Reed Abelson, “From Bulls to Bears and Back Again,” The New York Times, July 28, 1996, p. D1.

  24. Robert McGough and Patrick McGeehan, “Garzarelli Proves She Can Still Roil the Market,” The Wall Street Journal, July 24, 1996, p. C1.

  25. James Cramer, The Street, December 29, 1999.

  26. Tversky and Kahneman, “Causal Schemata in Judgments Under Uncertainty”; Daniel Kahneman and Amos Tversky, “On the Psychology of Prediction,” Psychological Review 80 (1973): 237–251.

  27. Paul Slovic, Baruch Fischhoff, and Sarah Lichtenstein, “Behavioral Decision Theory,” Annual Review of Psychology 28 (1977): 1–39.

  28. Kahneman and Tversky, “On the Psychology of Prediction.”

  29. The reader may observe that this is the same course of action recommended in discussing the “inside view” versus the “outside view” in chapter 8.

  30. Tversky and Kahneman, “Judgment Under Uncertainty”; Tversky and Kahneman, “Intuitive Predictions.”

  31. Kahneman and Tversky, “On the Psychology of Prediction.”

  32. Roger G. Ibbotson and Rex A. Sinquefield, Market Results for Stocks, Bonds, Bills and Inflation for 1926–2010, 2011 Classic Yearbook (Chicago: Morningstar, 2011); Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past (1926–1976) and the Future (1977–2000) (Charlottesville, Va.: Financial Analysts Research Foundation, 1977).

  33. “The Death of Equities,” BusinessWeek, August 13, 1979.

  34. Tversky and Kahneman, “Intuitive Predictions.”

  35. Herbert Simon, “Theories of Decision Making in Economics and Behavioral Sciences,” American Economic Review 49 (1959): 273.

  36. Ibid., pp. 306–307.

  37. B. Shiv and A. Fedorikhin, “Heart and Mind in Conflict: Interplay of Affect and Cognition in Consumer Decision Making,” Journal of Consumer Research 26 (1999): 278–282.

  38. Nelson Cowan, “The Magical Number 4 in Short-Term Memory: A Reconsideration of Mental Storage Capacity,” Behavioral and Brain Sciences 24 (2000): 87–185.

  39. Kahneman and Tversky, “On the Psychology of Prediction.”

  40. Tversky and Kahneman, “Judgment Under Uncertainty.”

  41. Benjamin Graham, David Dodd, Sidney Cottle, and Charles Tatham, Security Analysis, 4th ed. (New York: McGraw-Hill, 1962), p. 424.

  42. See, e.g., George Katona, Psychological Economics (New York: American Elsevier, 1975).

  43. S. C. Lichtenstein and Paul Slovic, “Reversals of Preference Between Bids and Choices in Gambling Decisions,” Journal of Experimental Psychology 89 (1971): 46–55; S. C. Lichtenstein, B. Fischhoff, and L. Phillips, “Calibration of Probabilities: The State of the Art,” in Decision Making and Change in Human Affairs, ed. H. Jungermann and G. de Zeeuw (Amsterdam: D. Reidel, 1977).

  44. Baruch Fischhoff, “Hindsight Does Not Equal Foresight: The Effect of Outcome Knowledge on Judgment Under Uncertainty,” Journal of Experimental Psychology: Human Perception and Performance 1 (August 1975): 288–299; Baruch Fischhoff, “Hindsight: Thinking Backward?” Psychology Today, April 1975, p. 8; Baruch Fischhoff, “Perceived Informativeness of Facts,” Journal of Experimental Psychology: Human Perception and Performance 3 (1977): 349–358; Baruch Fischhoff and Ruth Beyth, “I Knew It Would Happen: Remembered Probabilities of Once-Future Things,” Organizational Behavior and Human Performance 13, No. 1 (1975): 1–16; Paul Slovic and Baruch Fischhoff, “On the Psychology of Experimental Surprises,” Journal of Experimental Psychology: Human Perception and Performance 3 (1977): 511–551.

  45. John F. Lyons, “Can the Bond Market Survive?” Institutional Investor 3 (May 1969): 34.

  CHAPTER 4: CONQUISTADORS IN TWEED JACKETS

  1. Winston Churchill, radio speech, 1939.

  2. Edward Gibbon, The History of the Decline and Fall of the Roman Empire, Vol. 6, chap. 37, para. 619.

  3. Louis Bachelier, “Théorie de la Speculation,” trans. A. James Boness, in The Random Character of Stock Market Prices, ed. Paul H. Cootner (Cambridge, Mass.: MIT Press, 1964), pp. 17–78.

  4. Harry V. Roberts, “Stock Market Patterns and Financial Analysis: Methodological Suggestions,” Journal of Finance 14 (March 1959): 1–10.

  5. M. F. M. Osborne, “Brownian Motion in the Stock Market,” Operations Research 7, No. 2 (March–April 1959): 145–173.

  6. Fischer Black, “Implications of the Random Walk Hypothesis for Portfolio Management,” Financial Analyst Journal 27, No. 2 (March–April 1971): 16–22.

  7. Arnold B. Moore, “Some Characteristics of Changes in Common Stock Prices,” in The Random Character of Stock Market Prices, ed. Paul H. Cootner (Cambridge, Mass.: MIT Press, 1964), pp. 139–161.

  8. Clive W. J. Granger and Oskar Morgenstern, “Spectral Analysis of New York Stock Market Prices,” Kyklos 16 (1963): 1–27.

  9. Eugene F. Fama, “The Behavior of Stock Market Prices,” Journal of Business 38 (January 1965): 34–105.

  10. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (May 1970): 383–417.

  11. Fama, “The Behavior of Stock Market Prices.”

  12. Black, “Implications of the Random Walk Hypothesis.”

  13. Burton G. Malkiel, A Random Walk Down Wall Street (New York: Norton, 1973), p. 126.

  14. Black, “Implications of the Random Walk Hypothesis.”

  15. Fama, “Efficient Capital Markets.”

  16. Benjamin Graham and David Le Fevre Dodd, Security Analysis (New York: McGraw-Hill, 1951).

  17. Alfred Cowles III, “Can Stock Market Forecasters Forecast?” Econometrica 1, Issue B (1933): 309–324; Alfred Cowles, “Stock Market Forecasting,” Econometrica (1944): 206–214.

  18. Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and Other Institutional Investors: A New Perspective, Twentieth Century Fund Study (New York: McGraw Hill, 1971).

  19. Michael Jensen, for example, measured the record of 155 mutual funds between 1945 and 1964, adjusting for risk as the academics defined it, and found that only 43 of 115 funds outperformed the market after commissions. In 1970, Irwin Friend, Marshall Blume, and Jean Crockett of the Wharton School made the most comprehensive study of mutual funds to that time. They measured 136 funds between January 1, 1960, and June 30, 1968, and found that the funds returned an average of 10.7 percent annually. During the same time span, shares on the New York Stock Exchange averaged 12.4 percent annually. With value weighting for the number of outstanding shares of each company (which gave far more emphasis to the changes of the larger companies), the increase was 9.9 percent. See Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (May 1968): 389–416; and Friend, Blume, and Crockett, Mutual Funds and Other Institutional Investors.

  20. No-load funds and funds with low sales charges perform marginally better.

  21. Eugene F. Fama, Lawrence Fisher, Michael Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,�
� International Economic Review 10 (February 1969): 1–21; James H. Lorie and Mary T. Hamilton, The Stock Market: Theories and Evidence (Homewood, Ill.: Dow Jones-Irwin, 1973), pp. 171ff.

  22. Ray Ball and Phillip Brown, “An Empirical Evaluation of Accounting Income Numbers,” Journal of Accounting Research 6 (Fall 1968): 159–178.

  23. Here the efficient-market theorists acknowledge a paradox. Since it is fundamental analysis that is largely responsible for keeping markets efficient, if enough practitioners believed the efficient-market hypothesis and stopped their analytic efforts, markets might well become inefficient.

  24. Daniel Seligman, “Can You Beat the Stock Market?” Fortune, December 26, 1983, p. 84.

  25. James H. Lorie and Victor Niederhoffer, “Predictive and Statistical Properties of Insider Trading,” Journal of Law and Economics 11 (April 1968): 35–53.

  26. Fama, “Efficient Capital Markets.”

  27. Eugene F. Fama, “Efficient Markets: II,” Journal of Finance 46 (December 1991): 1575–1617.

  28. Eugene F. Fama, “Market Efficiency, Long-Term Returns, and Behavioral Finance,” Journal of Financial Economics 49 (1998): 283–306.

  29. Fama, “Efficient Markets: II.”

  30. Ibid.

  31. Seligman, “Can You Beat the Stock Market?”

  32. Paul H. Cootner, “Stock Prices: Random Versus Systematic Changes,” Industrial Management Review (Spring 1962): 25.

  CHAPTER 5: IT’S ONLY A FLESH WOUND

  1. Bob Tamarkin, The New Gatsbys: Fortunes and Misfortunes of Commodities Traders (New York: Morrow, 1985).

  2. William Glaberson, “How Risk Rattled the Street,” The New York Times, November 1, 1987.

  3. Tamarkin, The New Gatsbys.

  4. Ibid.

  5. Hayne E. Leland, “Who Should Buy Portfolio Insurance?” Journal of Finance 35, No. 2 (May 1980): 581–594.

  6. Barbara Donnelly, “Is Portfolio Insurance All It’s Cracked Up to Be?” Institutional Investor II (November 1986): 124–139. Quote is on p. 126.

  7. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000).

  8. Ibid.

  9. Ibid.

  10. Ibid., p. 78.

  11. Ibid., p. 159.

  12. Paul Krugman, “How Did Economists Get It So Wrong?” The New York Times, September 6, 2009.

  13. John Cassidy, “Rational Irrationality: Interview with Eugene Fama,” The New Yorker, January 13, 2010. Online at www.newyorker.com.

  CHAPTER 6: EFFICIENT MARKETS AND PTOLEMAIC EPICYCLES

  1. Maurice A. Finocchiaro, Retrying Galileo, 1633–1992 (London: University of California Press, 2007).

  2. J. Michael Murphy, “Efficient Markets, Index Funds, Illusion, and Reality,” Journal of Portfolio Management 4, No. 1 (1977): 5–20.

  3. Ibid. See also Shannon Pratt, “Relationship Between Variability of Past Returns and Levels of Future Returns for Common Stocks, 1926–60,” Business Valuation Review 27, No. 2 (Summer 2008); Fischer Black, Michael Jensen, and Myron Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in the Theory of Capital Markets, ed. M. Jensen (New York: Praeger, 1972); R. Richardson Pettit and Randolph Westerfield, “Using the Capital Asset Pricing Model and the Market Model to Predict Securities Returns,” Journal of Financial and Quantitative Analysis 9, No. 4 (September 1974): 579–605 (published by the University of Washington School of Business Administration); Merton Miller and Myron Scholes, “Rates of Return in Relation to Risk: A Re-Examination of Some Recent Findings,” in Studies in the Theory of Capital Markets, ed. M. Jensen (New York: Praeger, 1972); Nancy Jacob, “The Measurement of Systematic Risk for Securities and Portfolios: Some Empirical Results,” Journal of Financial and Quantitiative Analysis 6 (March 1971), pp. 815–833 (published by Cambridge University Press).

  4. Dale F. Max, “An Empirical Examination of Risk-Premium Curves for Long-Term Securities, 1910–1969,” unpublished Ph.D. thesis, University of Iowa, 1972, microfilm Order No. 73-13575.

  5. Marshall Blume and Irwin Friend, “A New Look at the Capital Asset Pricing Model,” in Methodology in Finance-Investments, ed. James L. Bicksler (Lexington, Mass.: Heath-Lexington, 1972), pp. 97–114.

  6. Albert Russell and Basil Taylor, “Investment Uncertainty and British Equities,” Investment Analyst (December 1968): 13–22.

  7. Quoting J. Michael Murphy, “Efficient Markets” (the foregoing three citations are references made by Murphy within the quoted passage).

  8. Robert A. Haugen and James A. Heins, “Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles,” Journal of Financial and Quantitative Analysis (December 1975): 775–784.

  9. Paul Krugman, “How Did Economists Get It So Wrong?” The New York Times, September 6, 2009.

  10. Eugene Fama and James MacBeth, “Risk, Return, and Equilibrium: Empirical Tests,” Journal of Political Economy 81 (1973): 607–636; see also Eugene Fama, “Efficient Capital Markets: A Review of Theory and Empirical Works,” Journal of Finance 25 (1970): 383–417.

  11. See Eugene Fama and Kenneth French, “The Cross Section of Expected Stock Returns,” Journal of Finance 67 (1992): 427–465.

  12. See Eric N. Berg, “Market Place: A Study Shakes Confidence in the Volatile-Stock Theory,” The New York Times, February 18, 1992, p. D1.

  13. Bill Barnhart, “Professors Say Beta Too Iffy to Trust: A Substitute Stock Scorecard Is Proposed,” Chicago Tribune, July 27, 1992, p. 3.

  14. Terence P. Pare, “The Solomon of Stocks Finds a Better Way to Pick Them,” Fortune, June 1, 1992, p. 23.

  15. Bill Barnhart, “Professors Say Beta Too Iffy.”

  16. Mary Beth Grover, “Slow Growth,” Forbes, October 12, 1992, p. 163.

  17. David Dreman, “Bye-Bye to Beta,” Forbes, March 30, 1992, p. 148.

  18. Barnhart, “Professors Say Beta Too Iffy.”

  19. Eugene F. Fama and Kenneth R. French, “The CAPM Is Wanted Dead or Alive,” Journal of Finance 5, Issue 5 (December 1996): 1947–1958.

  20. Ibid.

  21. Eugene F. Fama, “Market Efficiency, Long-Term Returns, and Behavioral Finance,” Journal of Financial Economics 49 (1998): 208–306.

  22. George M. Frankfurter, “The End of Modern Finance,” Journal of Investing 3, No. 3 (Fall 1994).

  23. The impact of beta went far beyond the market. The capital asset pricing model had long been used by corporate managers to determine the attractiveness of new ventures. Because the accepted wisdom holds that companies with higher betas must pay commensurately higher returns, chief financial officers of high-beta companies might be loath to invest in new plants unless they feel they can earn the extra dollop of return. As one business consultant said, “Dethroning the model may have been the best thing that has happened to American business” (Pare, “The Solomon of Stocks”). CAPM, it seems, resulted in bad business decisions in corporate America for a long time.

  24. Jonathan Burton, “Revisiting the Capital Asset Pricing Model,” interview with William Sharpe, Dow Jones Asset Manager (May–June 1998): 20–28. Cited with permission.

  25. Milton Friedman, “The Methodology of Positive Economics,” in Essays on Positive Economics (Chicago: University of Chicago Press, 1953), p. 15.

  26. Fama, “Market Efficiency.”

  27. Fama, “Efficient Capital Markets.”

  28. EMH thus creates something of a paradox, for if professionals are important to the operation of the efficient market—if they do help to keep price synonymous with value—they must also, according to EMH, be dismal failures in the primary goal of their profession: helping their clients outperform the market.

  29. J. Michael Murphy, “Efficient Markets, Index Funds, Illusion, and Reality.”

  30. Ibid., p. 10.

  31. Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (May 1968): 389–416.

  32. J. Michael Murphy, “Efficient Marke
ts, Index Funds, Illusion, and Reality.”

  33. As indicated, this would exclude a minute number of extraordinarily skilled professionals using extensive resources for only their own benefit.

  34. Tim Loughran and Jay Ritter, “The New Issues Puzzle,” Journal of Finance 50, No. 1 (1995): 23–51.

  35. Fama and French, “The Cross-Section of Expected Stock Returns.”

  36. Burton G. Malkiel, A Random Walk Down Wall Street (New York: Norton, 1973).

  37. R. Ball and P. Brown, “An Empirical Evaluation of Accounting Income Numbers,” Journal of Accounting Research 6 (1968): 159–178.

  38. V. Bernard and J. Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics 13 (1990): 205.

  39. Fama, “Market Efficiency.”

  40. Eugene Fama, Lawrence Fisher, Michael Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (1969): 1–21.

  41. See chap. 17 in Contrarian Investment Strategies: The Next Generation for more details and an examination of the chart.

  42. David L. Ikenberry, Graeme Rankine, and Earl K. Stice, “What Do Stock Splits Signal?” Journal of Financial and Quantitative Analysis 31, No. 3 (September 1996): 357–375.

  43. Hemang Desai and Prem C. Jain, “Long-Run Common Stock Returns Following Stock Splits and Reverse-Splits,” Journal of Business 70 (1997): 409–433.

  44. Ray Ball and Philip Brown, “An Empirical Evaluation of Accounting Income Numbers.”

  45. Myron S. Scholes, “The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices,” Journal of Business 45 (1972): 179–211.

  46. Eugene Fama, “Efficient Capital Markets: II,” Journal of Finance 46 (1991): 1601.

  47. Gregor Andrade, Mark Mitchell, and Erik Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15, No. 2 (2001): 103–120; Michael C. Jensen and Richard S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1983): 5–50; Gregg A. Jarrell, James A. Brickley, and Jeffry M. Netter, “The Market for Corporate Control: The Empirical Evidence Since 1980,” Journal of Economic Perspectives 2, No. 1 (1998): 49–68.