Saturday, October 25, 2008

The Contrarian Investor

I wish I had written this book. Although it was published in 1979, the topics it covers are still the bleeding edge of investment science today -- behavioral science and the herd effect, value investing, low price-to-earnings, and cash flow.

The only area in which I differ with David Dreman is in technical analysis. He cites a fair amount of academic evidence against technical analysis. I haven't looked at that research, but studies of technical analysis are easily cherrypicked and misinterpreted. The fact that 90%+ of professional Forex traders use technical analysis is evidence enough of its usefulness. However, Dreman points out the ridiculousness of the other extreme, the efficient markets hypothesis, and the truth is that much of technical analysis is of dubious use.

Since much of this stuff is review for me, I skimmed it. He cites plenty of interesting information, including some psychology literature that I'd never heard of such as Gustave LeBon's The Crowd and Irving Jarvis's Victims of Groupthink, and a bunch of studies showing that experiments frequently make mistakes. Other literature was familiar, such as Muzafer Sherif's light experiment (when "confederates" in a study estimate the distance of light from them, the subjects yield to the judgment of the crowd) and Tversky and Kahneman's look at cognitive biases and judgmental heuristics.

Since the book was written in the 70s, the last chapter of the book is devoted to inflation. Conventional wisdom of the time was that inflation made stocks a poor investment. Dreman particularly focuses upon the Modigliani and Cohn position that professional investors just don't understand how inflation impacts equities.

First, investors confuse nominal and real interest rates (real interest = nominal - inflation). Since bonds pay high nominal rates in inflationary times, such as 9 percent in 1979 when inflation was 7 percent, investors look for rates of return from stocks in excess of 9 percent (the excess to adjust for rate) instead of in excess of the real rate of 2 percent. (UPDATE 2009-10-7: This paragraph doesn't make any sense to me right now. Why would investors looking for higher rates of return from stocks lead to them outperforming bonds? Outperformance occurs when an investment is not valued highly enough...)

Second, investors don't account fully for the effects of inflation. Inflation may create inflated profits (under the last-in first-out accounting method) and depreciation is exacerbated, but corporations benefit from being able to pay back their debt on much cheaper terms -- since the debt is relatively fixed and their income is being inflated.

Put together, these two factors make equity investments much better than bonds -- generating something like twice the return over a 10-year period.

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