David Dreman on How to Invest Like a Contrarian

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David Dreman on How to Invest Like a Contrarian

If you’re the kind of investor who believes in the wisdom of crowds, David Dreman has a thing or two he’d like to say to you. Since the 1970s, Dreman, chairman and managing director of Dreman Value Management, has been championing a value-oriented investing philosophy that favors stocks with low P/E ratios. In his newly released Contrarian Investment Strategies: The Psychological Edge an update of his 1998 best-seller Contrarian Investment Strategies: The Next Generation, Dreman explains the psychological principles underlying his approach and how emotions can lead investors astray. He shared his insights on the past, present, and future with Morningstar.com.

In your book you write that both professional and amateur investors are subject to strongly held feelings and emotions that skew their perceptions of probability. Is there any way to help investors control these impulses, or are they an inescapable part of human nature?
The impulses are very powerful on all classes of investors, and because they are emotional, they recur repeatedly. Because of these emotional forces, investors often cannot learn from the past. However, the book provides several dozen rules that, if followed, will prevent readers from making most of the costlier mistakes that are so common in the marketplace. The answers often appear to be easy to understand. But carrying them out is far more difficult because of the emotional forces I described in the text.

One of our most important rules is to buy stocks that trade at below-market P/E multiples. Academic studies, and our own, ranging over 65 years show that low P/Es and other contrarian strategies have consistently outperformed the market over time. A second important rule is not to rely on finely tuned earnings estimates. Although most analysts believe that if earnings come in even 3% under estimates, a stock can fall sharply, the average consensus miss since the early 1970s has been closer to 50%.

Your book is highly critical of the efficient-market hypothesis, saying the theory is flawed because it assumes rational behavior on the part of investors. But don’t criticisms of EMH, valid though they may be, overlook the value of indexing as a cost-efficient, tax-efficient strategy for many small investors?
The question is a good one. Studies going back decades show that only about 10% of money managers outperform the market in any 10-year period. So indexing is a good course for most investors to take. Indexing was recommended by EMH advocates because of the belief that sophisticated investors keep market prices where they should be. In effect, we recommend indexing for precisely the opposite reason. Far too many money managers underperform the market because of the psychological barriers noted above. more than 70 years that show the superior performance of these strategies.

Read More: http://news.morningstar.com/articlenet/article.aspx?id=540504

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