Book Review Of 'Contrarian Investment Strategies: The Psychological Edge'

by: Behavioral Investors

Having read and enjoyed his 1998 "Contrarian Investment Strategies: The Next Generation", I was pleased to see this comprehensive updated edition ("Contrarian Investment Strategies: The Psychological Edge")by longtime contrarian value investor David Dreman. By and large the content of the book is entirely new from the prior version; encompassing a brief discussion of research findings in behavioral finance and their relevance to value investing, a fairly devastating critique of the widely-used conventional concepts of risk and return embodied in the efficient market hypothesis (EMH), and a thorough (though not entirely novel) review of the significant long-term outperformance of several basic value investing strategies.

Contrarian Investment Strategies

Behavioral finance: theory and applications to value investing

Readers who have followed behavioral economics may find his descriptions occasionally a little stilted, but in general Dreman provides a useful summary of several basic findings on human behavioral biases and heuristics in financial decision-making, and how these create opportunities for value investors to outperform significantly over the long term. As I think most of its practitioners would agree, at its core behavioral investing is essentially value investing: an attempt to avoid and reverse the systematically poor performance of the majority of mainstream investors by avoiding biases through an explicit focus on objective measures of business value.

As a neurologist, I was particularly interested by Dreman's mention of the role of the neurotransmitter dopamine in expectation and reward. As Dreman expostulates, a large part of the significant excess returns of value stocks are realized subsequent to positive earnings surprises, which have a systematically much greater positive effect on stocks which are undervalued using basic metrics than on their overvalued peers. The representativeness heuristic causes investors to simplistically label individual companies as "good" or "bad" investments regardless of their current valuation, developing binary and often unrealistic expectations about future results. Overconfidence and biased self-attribution lead to inaccurate perception of the accuracy of earnings estimates developed by analysts and investors themselves, making surprises both far more frequent and far more extreme than conventional investors anticipate. As a gross simplification, the neurobiology of the dopamine reward system conditions human beings to experience pleasure and pain in proportion to the degree to which their actual experiences depart from their prior expectations of them. The interaction of these biases sets the stage for extreme positive returns from upside surprises in the undervalued stocks neglected and shunned by most investors, as well as disproportionately painful downside surprises in the most popular stocks (the very stocks chased by the majority of individual and institutional investors, who coincidentally have performed so poorly while value investors have done rather well).

Dreman may somewhat overstate the degree to which a single such surprise accounts for the durable long-term outperformance of value stocks: the evidence shows that the difference in excess return between undervalued stocks experiencing positive and negative surprises becomes less significant after 3 quarters, while both categories outperform the market strongly for more than a 5 to 8 year period. However, I strongly agree that understanding the actual behavioral and neural substrates of human decision making provides a much more comprehensive and powerful framework for investment strategy than a blind reliance on convenient EMH assumptions that remain impossible for most conventional investors to abandon, yet have been thoroughly and demonstrably discredited by years of empirical evidence.

"The New Dark Ages": a frontal assault on efficient market assumptions

I have always had somewhat mixed feelings about attempts to directly attack the efficient market hypothesis in book form. The degree of commitment to assumptions of rational behavior among conventional investors is so ingrained (in the face of decades of clear evidence to the contrary) that such attempts are almost invariably preaching to the choir. From a selfish perspective, it's more profitable to personally identify and act on mispriced investment opportunities resulting from market misperceptions than to spend time proselytizing the merits of deep value investing to a general audience, many of whom will realistically never be able to embrace such a strategy for behavioral reasons. Nevertheless Dreman provides a trenchant and valuable critique, with a particular focus on instances where EMH assumptions about the nature of risk and return have been repeatedly violated. In spite of some preexisting familiarity, I came away rather amazed by the lack of good real-world evidence behind many of the financial models still being used today, and the resulting inability of conventional investors to consider factors such as liquidity, leverage, and intrinsic business value in thinking about risk and return.

Dreman is at his best when narrating his own experiences as an analyst and investor during multiple periods of optimism and pessimism, spanning multiple fascinating periods of irrationality including the Nifty Fifty, the "go-go" 1960s and subsequent bear market and rejection of stocks, the turn-of-the-century internet bubble, and so on. His clearly worded exposition of how naive EMH assumptions about the nature of volatility, risk, and liquidity contributed to the 1987 crash (and yet again the Long Term Capital Management debacle, and the 2000s mortgage securitization boom and bust) was particularly telling.

Contrarian investment strategies: the psychological edge?

In view of the above insights and the title, I was hoping for a more nuanced discussion of some of the specific applications of behavioral finance in fine-tuning a basic value investing approach. The "contrarian" strategies discussed in the book are neither particularly novel nor explicitly different from basic ratio-based value strategies (price/earnings, price/book, price/cash flow, dividend yield, and rankings of the same metrics relative to firms within the same industry) which should be familiar to any reader of Graham or O'Shaughnessy, or indeed to most market participants. There is something to be said for adhering to a rules-based value methodology that removes human bias from the equation. For example, Joel Greenblatt has recently presented evidence that most individual and institutional investors who attempted to individual stock selection based on adding their personal judgements to results of a basic "Magic Formula" screen have in general substantially underperformed a simpler mechanical strategy using raw formula rankings themselves. For most investors, an attempt to apply subjective judgement simply reintroduces the biases which a formulaic approach to value investing is meant to eliminate.

However. the fact remains that over-reliance on raw reported valuation ratios can in many cases be a naive strategy with significant pitfalls for investors. As one trivial example, in recent years many investors have been seriously blindsided by investing in fraudulent Chinese reverse mergers, where apparent undervaluation on reported numbers could in most cases be belied by a modicum of individual research by a seasoned value investing practitioner, however subjective this may seem. Many entirely mechanical "quant" strategies being marketed to the public as value investing have in fact backfired. To the extent that very simple ratio-based methods become popular, there will be an increasing premium for value investors who can successfully incorporate subjective judgements while attempting to consciously avoid behavioral errors. This is likely to be a difficult and nuanced task that few can realistically achieve, but is an important part of the skill set of highly successful value investors such as Warren Buffett, so it's a pity that Dreman did not discuss the many instances where behavioral finance can help guide judgements of a more subjective nature.

Conclusion

Apart from the basic value strategies described above, the final chapters do include some discussion of several important situational sources of market risk arising from behavioral factors. Dreman again makes points worth repeating about the intellectual bankruptcy of the traditional EMH concepts of risk based on historical volatility and beta, assumptions still in use today by all too many market participants despite repeated devastating failures in the past. Drawing insightfully on the lessons of 1987 (portfolio insurance), 1998 (LTCM leveraged arbitrage) and 2008 (mortgage securitization), Dreman correctly emphasizes the significant roles of liquidity and leverage as intrinsic sources of real risk, which are strangely not perceived as risk by the majority of conventional investors.

All in all, Dreman's book is a solid presentation of many core research findings about the long-term outperformance of basic value strategies, and draws valid parallels between basic value investing and behavioral finance, in addition to illustrating how the prevalence of EMH assumptions contribute to the development of often glaring misperceptions by conventional investors about real-world risk and return. Readers more interested in an introductory exposition of behavioral and neuroeconomic research may enjoy Jason Zweig's, "Your Money and Your Brain," while those wanting a more comprehensive exploration of direct applications in behavioral finance may be interested in James Montier's "Behavioural Investing: A Practitioner's Guide," or "The Little Book of Behavioral Investing" by the same author.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.