Lessons from David Dreman (Part 1)

David Dreman founded Dreman Value Management in 1977 and has written many books and articles on contrarian investing. In this mini-series I will highlight certain aspects of his investment philosophy that resonate strongly with me.

According to Dreman, sound investment decisions are obstructed by psychological biases that I have called heuristic thinking. Crowd behavior is therefore irrational, which leads to market bubbles and violent selloffs. Contrarian investing aims to profit from the excess.

Dreman discusses the representativeness heuristic: human tendency to draw analogies and see similarities in things that are completely different. Overemphasis on similarity leads to miscalculation if we forget to assess the actual probability of an event occurring. One example would be recognizing a company as belonging to the automotive industry and remembering what happened last time an automotive stock was purchased. Representativeness reduces perceived importance given to the variables critical in determining actual probability of the event (e.g. the stock moving higher).

Dreman discusses the law of small numbers, which is a judgmental bias that occurs when one assumes characteristics of a sample population can be estimated from a small number of observations or data points. An example would be investors flocking to the hottest mutual fund. Research suggests funds that outperform in one time period often underperform in the next. Investors also tend to follow stock analysts who have demonstrated recent accuracy rather than checking the analyst’s performance over time for a logical measure of accuracy.

Investors ignore regression to the mean. Data show a tendency for valuations and returns to revert back to long-term averages—a conclusion overlooked by investors who pile in to buy a hot stock or rush to dump out-of-favor shares.

Investors fall prey to information overload, which is related to information bias. When under siege by information, people tend to see only what they are interested in while blocking out the rest. This is related to confirmation bias. Information bias is a delusion that more information guarantees better decision making.

In the next post I will review Dreman’s recommendations to overcome heuristic thinking.