Contrarian Investment Strategies The Psychological Edge Book by David Dreman
Today, David Dreman’s asset management firm successfully manages more than 5 billion dollars. Most of his success is due to the principals that he shares with the world in this book. The topics covered include emotions in the stock market, 1987 market crash emotions, ignoring analysts, liquidity, and leverage, and how to be a contrarian.
Emotions in the Stock Market
In essence, people avoid stocks that burned them before and stick with those that produced gains. Dreman suggests that this is wrong and it is not based on objective analysis. Most people look for evidence that reaffirms what they already believe. Dreman also found that the IPO price made no impact on buyers. Instead, most buyers concentrated on the hype around an IPO.
Dreman urges trader to be skeptical of what analysts tell them. Many analysts are paid to promote a stock even when they know it is not great. He points out that even the best are usually only right half of the time. Additionally, he mentions scandals where analysts have been paid to hype bad stocks by companies such as Citigroup.
The Market Crash of 1987
Dreman claims, with evidence that the crash of 1987 was due to emotions and not fundamentals. He says that the P/E of the S&P500 fell from 20 to 13 in a short while. However, 13 was still a good number. The hype about another 1929 market crash was what caused traders to panic. It is also worth noting that in 1929 the P/E was through the roof.
Liquidity and Leverage
David Dreman disagrees with the Efficient Market Hypothesis since he believes it is wrong on various assumptions. He provides an example of a hedge fund that lost a huge amount of money in the 90s due to liquidity and leverage issues. Dreman says that the two are like hidden risks since they are not always obvious from checking the history of volatility. For instance, he points to the fact that liquidity drops when stock prices fall fast. As a result, this leads to prices volatility, which was not visible in the short-term history. He warns readers never to attempt to predict volatility.
How to Trade like a Contrarian
Dreman says that contrarians avoid picks by analysts and buy value stock with low P/E, low price to cash flow, low price to book, and other factors. While it is good to buy cheap stock, Dreman wants traders never to buy a firm, which is making losses. When the contrarian indicators approach those of the overall market, this is time to sell no matter how good the prospects look. He is also a bear on bonds. He argues that the risk is not worth the reward of buying bonds.
In general, Dreman warns traders to avoid the hype, recommendations by analysts, and emotions. Instead, he urges traders to focus on liquidity and leverage as the risk factors instead of correlation and volatility. In essence, traders should buy value stock with low prices and sell when they get to fair market levels.