INTRODUCTION
1. Bradley Keoun and Phil Kuntz, “Wall Street Aristocracy Got $1.2 Trillion in Secret Loans,” Businessweek, August 22, 2011.
2. J. C. Bogle, The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Hoboken, N.J.: Wiley, 2007), p. 81.
CHAPTER 1: PLANET OF THE BUBBLES
1. Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (New York: Noonday, 1974), p. 55. Originally published in London in 1841 by Richard Bentley.
2. Alan Greenspan, “Economic Volatility,” remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wy., August 30, 2002.
3. Virginia Cowles, The Great Swindle: The Story of the South Sea Bubble (London: Crowley Feature, 1960).
4. Mackay, Extraordinary Popular Delusions, pp. 19–20.
5. Ibid.
6. Gustave Le Bon, The Crowd (New York: Macmillan, 1896), p. 2.
7. Ibid., pp. 23–57.
CHAPTER 2: THE PERILS OF AFFECT
1. M. L. Finucane, A. Alhakami, P. Slovic, and S. M. Johnson, “The Affect Heuristic in Judgements of Risks and Benefits,” Journal of Behavioral Decision Making 13 (2000): 1–17.
2. Ibid.
3. Paul Slovic, Melissa L. Finucane, Ellen Peters, and Donald G. MacGregor, “Rational Actors or Rational Fools? Implications of the Affect Heuristic for Behavioral Economics,” in Behavioral Economics and Neoclassical Economics: Continuity or Discontinuity? Sponsored by the American Institute for Economic Research, Great Barrington, Mass., July 19–21, 2002. This paper is a revised version of Paul Slovic, Melissa Finucane, Ellen Peters, and Donald G. MacGregor, “The Affect Heuristic,” in Heuristics and Biases: The Psychology of Intuitive Judgment, ed. T. Gilovich, D. Griffin, and D. Kahneman (New York: Cambridge University Press, 2002), pp. 397–420. An earlier version of this paper was published in Journal of Socio-Economics 31, No. 5 (2002): 329–342.
4. S. Epstein, “Integration of the Cognitive and Psychodynamic Unconscious,” American Psychologist 49 (1994): 710.
5. Slovic et al., “Rational Actors or Rational Fools?” p. 17.
6. Ibid., p. 13.
7. G. F. Loewenstein, E. U. Weber, C. K. Hsee, and E. S. Welch, “Risk as Feelings,” Psychological Bulletin 127 (2001): 267–286.
8. Robert J. Shiller, “Initial Public Offerings: Investor Behavior and Underpricing,” Yale University, September 24, 1989. Photocopied.
9. Y. Rottenstreich and C. K. Hsee, “Money, Kisses and Electric Shocks: On the Affective Psychology of Risk,” Psychological Science 12 (2001): 185–190.
10. B. Fischhoff, P. Slovic, S. Lichtenstein, and B. Coombs, “How Safe Is Safe Enough? A Psychometric Study of Attitudes Towards Technological Risks and Benefits,” Policy Sciences 9 (1978): 127–152.
11. P. Slovic, D. G. MacGregor, T. Malmfors, and I. F. H. Purchase, Influence of Affective Processes on Toxicologists’ Judgements of Risk. Report No. 99-2 (Eugene, Ore.: Decision Research, 1999).
12. Slovic et al., “Rational Actors or Rational Fools?” p. 17.
13. A. S. Alhakami and P. Slovic, “A Psychological Study of the Inverse Relationship Between Perceived Risk and Perceived Benefit,” Risk Analysis 14, No. 6 (1994): 1085–1096.
14. Y. Ganzach, “Judging Risk and Return of Financial Assets,” Organizational Behavior and Human Decision Processes 83 (2001): 353–370.
15. D. T. Gilbert, E. C. Pinel, T. D. Wilson, S. J. Blumberg, and T. P. Wheatley, “Immune Neglect: A Source of Durability Bias in Affective Forecasting,” Journal of Personality and Social Psychology 75 (1998): 617–638.
16. Y. Trope and N. Liberman, “Temporal Construal and Time-Dependent Changes in Preference,” Journal of Personality and Social Psychology 79 (2000): 876–889. Y. Trope and N. Liberman, Temporal Construal (New York: New York University, Department of Psychology, 2001).
17. D. Dreman, S. Johnson, D. MacGregor, and P. Slovic, “A Report on the March 2001 Investor Sentiment Survey,” Journal of Psychology and Financial Markets 2 (2001): 126–134.
18. Slovic et al., “The Affect Heuristic.”
19. Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham and Dodd’s Security Analysis, 5th ed. (New York: McGraw-Hill, 1988).
CHAPTER 3: TREACHEROUS SHORTCUTS IN DECISION MAKING
1. Scott Plous, Psychology of Judgment and Decision Making (New York: McGraw-Hill, 1993).
2. “Death Odds,” Newsweek, September 24, 1990, p. 10.
3. Jaws. Zanuck/Brown Productions Universal Pictures, 1975.
4. Amos Tversky and Daniel Kahneman, “Judgments Under Uncertainty: Heuristics and Biases,” Science 185 (1974): 1124–1130.
5. Baruch Fischhoff, “Debiasing,” in Judgment Under Uncertainty: Heuristics and Biases, ed. D. Kahneman, P. Slovic, and A. Tversky (New York: Cambridge University Press, 1982).
6. A. Tversky, P. Slovic, and D. Kahneman (eds.), Judgment Under Uncertainty: Heuristics and Biases (New York: Cambridge University Press, 1982).
7. Amos Tversky and Daniel Kahneman, “Availability: A Heuristic for Judging Frequency and Probability,” Cognitive Psychology 5 (1973): 207–232.
8. Amos Tversky and Daniel Kahneman, “Intuitive Predictions: Biases and Corrective Procedures,” Management Science, Spring 1981; Amos Tversky and Daniel Kahneman, “Causal Schemata in Judgments Under Uncertainty,” in Progress in Social Psychology, ed. M. Fishbein (Hillsdale, N.J.: Lawrence Erlbaum Associates, 1973); Don Lyon and Paul Slovic, “Dominance of Accuracy Information and Neglect of Base Rates in Probability Estimation,” Acta Psychologica 40, No. 4 (August 1976): 287–298.
9. Amos Tversky and Daniel Kahneman, “Belief in the Law of Small Numbers,” Psychological Bulletin 76 (1971): 105–110.
10. Value Line New Issue Survey.
11. T. Loughran and J. Ritter, “The New Issues Puzzle,” Journal of Finance 50, No. 1 (1995): 23–51.
12. J. R. Ritter, “The Long-Run Performance of Initial Public Offerings,” Journal of Finance 46, No. 1 (1991): 3–27.
13. David Dreman and Vladimira Ilieva, “The Performance of IPO’s during the Great Bubble 1996–2002,” working paper, The Dreman Foundation, 2011.
14. H. Nejat Seyhun, “Information Asymmetry and Price Performance of IPOs,” working paper, University of Michigan, 1992.
15. M. Levis, “The Long-Run Performance of Initial Public Offerings: The UK Experience 1980–88,” Financial Management 22 (1993): 28–41.
16. Bharat Jain and Omesh Kini, “The Post-Issue Operating Performance of IPO Firms,” Journal of Finance 49 (1994): 1699–1726.
17. Loughran and Ritter, “The New Issues Puzzle,” 46.
18. Tversky, Slovic, and Kahneman, Judgment Under Uncertainty.
19. David Dreman, “Let’s Hoard Crude Oil,” Forbes, June 8, 2009, p. 104.
20. Tversky and Kahneman, “Belief in the Law of Small Numbers.”
21. Tversky and Kahneman, “Judgment Under Uncertainty: Heuristics and Biases,” pp. 1125–1126; Tversky and Kahneman, “Intuitive Predictions,” pp. 313–327.
22. Looking back briefly to “Judgments of Risk and Benefit Are Negatively Correlated,” on page 39, again we see this important psychological discovery played out clearly in the market. Investors believed not only that the dazzling performance of stocks during the bubble would provide better returns but that these stocks would prove to be less risky than the far safer but less exciting stocks in the S&P 500. The psychologists’ results in chapter 2 were thus dead-on. Neither investor assumption was correct: higher-performing stocks were not less but more risky than the far safer stocks in the S&P 500. Too, the S&P 500 didn’t go down nearly as much as the “hot hand” stocks after the market’s terrifying break. The S&P 500 also outperformed the “hot hand” stocks by a good margin over time.
23. Reed Abelson, “From Bulls to Bears and Back Again,” The New York Times, July 28, 1996, p. D1.
24. Robert McGough and Patrick McGeehan, “Garzarelli Proves She Can Still Roil the Market,” The Wall Street Journal, July 24, 1996, p. C1.
25. James Cramer, The Street, December 29, 1999.
26. Tversky and Kahneman, “Causal Schemata in Judgments Under Uncertainty”; Daniel Kahneman and Amos Tversky, “On the Psychology of Prediction,” Psychological Review 80 (1973): 237–251.
27. Paul Slovic, Baruch Fischhoff, and Sarah Lichtenstein, “Behavioral Decision Theory,” Annual Review of Psychology 28 (1977): 1–39.
28. Kahneman and Tversky, “On the Psychology of Prediction.”
29. The reader may observe that this is the same course of action recommended in discussing the “inside view” versus the “outside view” in chapter 8.
30. Tversky and Kahneman, “Judgment Under Uncertainty”; Tversky and Kahneman, “Intuitive Predictions.”
31. Kahneman and Tversky, “On the Psychology of Prediction.”
32. Roger G. Ibbotson and Rex A. Sinquefield, Market Results for Stocks, Bonds, Bills and Inflation for 1926–2010, 2011 Classic Yearbook (Chicago: Morningstar, 2011); Roger G. Ibbotson and Rex A. Sinquefield, Stocks, Bonds, Bills, and Inflation: The Past (1926–1976) and the Future (1977–2000) (Charlottesville, Va.: Financial Analysts Research Foundation, 1977).
33. “The Death of Equities,” BusinessWeek, August 13, 1979.
34. Tversky and Kahneman, “Intuitive Predictions.”
35. Herbert Simon, “Theories of Decision Making in Economics and Behavioral Sciences,” American Economic Review 49 (1959): 273.
36. Ibid., pp. 306–307.
37. B. Shiv and A. Fedorikhin, “Heart and Mind in Conflict: Interplay of Affect and Cognition in Consumer Decision Making,” Journal of Consumer Research 26 (1999): 278–282.
38. Nelson Cowan, “The Magical Number 4 in Short-Term Memory: A Reconsideration of Mental Storage Capacity,” Behavioral and Brain Sciences 24 (2000): 87–185.
39. Kahneman and Tversky, “On the Psychology of Prediction.”
40. Tversky and Kahneman, “Judgment Under Uncertainty.”
41. Benjamin Graham, David Dodd, Sidney Cottle, and Charles Tatham, Security Analysis, 4th ed. (New York: McGraw-Hill, 1962), p. 424.
42. See, e.g., George Katona, Psychological Economics (New York: American Elsevier, 1975).
43. S. C. Lichtenstein and Paul Slovic, “Reversals of Preference Between Bids and Choices in Gambling Decisions,” Journal of Experimental Psychology 89 (1971): 46–55; S. C. Lichtenstein, B. Fischhoff, and L. Phillips, “Calibration of Probabilities: The State of the Art,” in Decision Making and Change in Human Affairs, ed. H. Jungermann and G. de Zeeuw (Amsterdam: D. Reidel, 1977).
44. Baruch Fischhoff, “Hindsight Does Not Equal Foresight: The Effect of Outcome Knowledge on Judgment Under Uncertainty,” Journal of Experimental Psychology: Human Perception and Performance 1 (August 1975): 288–299; Baruch Fischhoff, “Hindsight: Thinking Backward?” Psychology Today, April 1975, p. 8; Baruch Fischhoff, “Perceived Informativeness of Facts,” Journal of Experimental Psychology: Human Perception and Performance 3 (1977): 349–358; Baruch Fischhoff and Ruth Beyth, “I Knew It Would Happen: Remembered Probabilities of Once-Future Things,” Organizational Behavior and Human Performance 13, No. 1 (1975): 1–16; Paul Slovic and Baruch Fischhoff, “On the Psychology of Experimental Surprises,” Journal of Experimental Psychology: Human Perception and Performance 3 (1977): 511–551.
45. John F. Lyons, “Can the Bond Market Survive?” Institutional Investor 3 (May 1969): 34.
CHAPTER 4: CONQUISTADORS IN TWEED JACKETS
1. Winston Churchill, radio speech, 1939.
2. Edward Gibbon, The History of the Decline and Fall of the Roman Empire, Vol. 6, chap. 37, para. 619.
3. Louis Bachelier, “Théorie de la Speculation,” trans. A. James Boness, in The Random Character of Stock Market Prices, ed. Paul H. Cootner (Cambridge, Mass.: MIT Press, 1964), pp. 17–78.
4. Harry V. Roberts, “Stock Market Patterns and Financial Analysis: Methodological Suggestions,” Journal of Finance 14 (March 1959): 1–10.
5. M. F. M. Osborne, “Brownian Motion in the Stock Market,” Operations Research 7, No. 2 (March–April 1959): 145–173.
6. Fischer Black, “Implications of the Random Walk Hypothesis for Portfolio Management,” Financial Analyst Journal 27, No. 2 (March–April 1971): 16–22.
7. Arnold B. Moore, “Some Characteristics of Changes in Common Stock Prices,” in The Random Character of Stock Market Prices, ed. Paul H. Cootner (Cambridge, Mass.: MIT Press, 1964), pp. 139–161.
8. Clive W. J. Granger and Oskar Morgenstern, “Spectral Analysis of New York Stock Market Prices,” Kyklos 16 (1963): 1–27.
9. Eugene F. Fama, “The Behavior of Stock Market Prices,” Journal of Business 38 (January 1965): 34–105.
10. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25 (May 1970): 383–417.
11. Fama, “The Behavior of Stock Market Prices.”
12. Black, “Implications of the Random Walk Hypothesis.”
13. Burton G. Malkiel, A Random Walk Down Wall Street (New York: Norton, 1973), p. 126.
14. Black, “Implications of the Random Walk Hypothesis.”
15. Fama, “Efficient Capital Markets.”
16. Benjamin Graham and David Le Fevre Dodd, Security Analysis (New York: McGraw-Hill, 1951).
17. Alfred Cowles III, “Can Stock Market Forecasters Forecast?” Econometrica 1, Issue B (1933): 309–324; Alfred Cowles, “Stock Market Forecasting,” Econometrica (1944): 206–214.
18. Irwin Friend, Marshall Blume, and Jean Crockett, Mutual Funds and Other Institutional Investors: A New Perspective, Twentieth Century Fund Study (New York: McGraw Hill, 1971).
19. Michael Jensen, for example, measured the record of 155 mutual funds between 1945 and 1964, adjusting for risk as the academics defined it, and found that only 43 of 115 funds outperformed the market after commissions. In 1970, Irwin Friend, Marshall Blume, and Jean Crockett of the Wharton School made the most comprehensive study of mutual funds to that time. They measured 136 funds between January 1, 1960, and June 30, 1968, and found that the funds returned an average of 10.7 percent annually. During the same time span, shares on the New York Stock Exchange averaged 12.4 percent annually. With value weighting for the number of outstanding shares of each company (which gave far more emphasis to the changes of the larger companies), the increase was 9.9 percent. See Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (May 1968): 389–416; and Friend, Blume, and Crockett, Mutual Funds and Other Institutional Investors.
20. No-load funds and funds with low sales charges perform marginally better.
21. Eugene F. Fama, Lawrence Fisher, Michael Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (February 1969): 1–21; James H. Lorie and Mary T. Hamilton, The Stock Market: Theories and Evidence (Homewood, Ill.: Dow Jones-Irwin, 1973), pp. 171ff.
22. Ray Ball and Phillip Brown, “An Empirical Evaluation of Accounting Income Numbers,” Journal of Accounting Research 6 (Fall 1968): 159–178.
23. Here the efficient-market theorists acknowledge a paradox. Since it is fundamental analysis that is largely responsible for keeping markets efficient, if enough practitioners believed the efficient-market hypothesis and stopped their analytic efforts, markets might well become inefficient.
24. Daniel Seligman, “Can You Beat the Stock Market?” Fortune, December 26, 1983, p. 84.
25. James H. Lorie and Victor Niederhoffer, “Predictive and Statistical Properties of Insider Trading,” Journal of Law and Economics 11 (April 1968): 35–53.
26. Fama, “Efficient Capital Markets.”
27. Eugene F. Fama, “Efficient Markets: II,” Journal of Finance 46 (December 1991): 1575–1617.
28. Eugene F. Fama, “Market Efficiency, Long-Term Returns, and Behavioral Finance,” Journal of Financial Economics 49 (1998): 283–306.
29. Fama, “Efficient Markets: II.”
30. Ibid.
31. Seligman, “Can You Beat the Stock Market?”
32. Paul H. Cootner, “Stock Prices: Random Versus Systematic Changes,” Industrial Management Review (Spring 1962): 25.
CHAPTER 5: IT’S ONLY A FLESH WOUND
1. Bob Tamarkin, The New Gatsbys: Fortunes and Misfortunes of Commodities Traders (New York: Morrow, 1985).
2. William Glaberson, “How Risk Rattled the Street,” The New York Times, November 1, 1987.
3. Tamarkin, The New Gatsbys.
4. Ibid.
5. Hayne E. Leland, “Who Should Buy Portfolio Insurance?” Journal of Finance 35, No. 2 (May 1980): 581–594.
6. Barbara Donnelly, “Is Portfolio Insurance All It’s Cracked Up to Be?” Institutional Investor II (November 1986): 124–139. Quote is on p. 126.
7. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000).
8. Ibid.
9. Ibid.
10. Ibid., p. 78.
11. Ibid., p. 159.
12. Paul Krugman, “How Did Economists Get It So Wrong?” The New York Times, September 6, 2009.
13. John Cassidy, “Rational Irrationality: Interview with Eugene Fama,” The New Yorker, January 13, 2010. Online at www.newyorker.com.
CHAPTER 6: EFFICIENT MARKETS AND PTOLEMAIC EPICYCLES
1. Maurice A. Finocchiaro, Retrying Galileo, 1633–1992 (London: University of California Press, 2007).
2. J. Michael Murphy, “Efficient Markets, Index Funds, Illusion, and Reality,” Journal of Portfolio Management 4, No. 1 (1977): 5–20.
3. Ibid. See also Shannon Pratt, “Relationship Between Variability of Past Returns and Levels of Future Returns for Common Stocks, 1926–60,” Business Valuation Review 27, No. 2 (Summer 2008); Fischer Black, Michael Jensen, and Myron Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” in Studies in the Theory of Capital Markets, ed. M. Jensen (New York: Praeger, 1972); R. Richardson Pettit and Randolph Westerfield, “Using the Capital Asset Pricing Model and the Market Model to Predict Securities Returns,” Journal of Financial and Quantitative Analysis 9, No. 4 (September 1974): 579–605 (published by the University of Washington School of Business Administration); Merton Miller and Myron Scholes, “Rates of Return in Relation to Risk: A Re-Examination of Some Recent Findings,” in Studies in the Theory of Capital Markets, ed. M. Jensen (New York: Praeger, 1972); Nancy Jacob, “The Measurement of Systematic Risk for Securities and Portfolios: Some Empirical Results,” Journal of Financial and Quantitiative Analysis 6 (March 1971), pp. 815–833 (published by Cambridge University Press).
4. Dale F. Max, “An Empirical Examination of Risk-Premium Curves for Long-Term Securities, 1910–1969,” unpublished Ph.D. thesis, University of Iowa, 1972, microfilm Order No. 73-13575.
5. Marshall Blume and Irwin Friend, “A New Look at the Capital Asset Pricing Model,” in Methodology in Finance-Investments, ed. James L. Bicksler (Lexington, Mass.: Heath-Lexington, 1972), pp. 97–114.
6. Albert Russell and Basil Taylor, “Investment Uncertainty and British Equities,” Investment Analyst (December 1968): 13–22.
7. Quoting J. Michael Murphy, “Efficient Markets” (the foregoing three citations are references made by Murphy within the quoted passage).
8. Robert A. Haugen and James A. Heins, “Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles,” Journal of Financial and Quantitative Analysis (December 1975): 775–784.
9. Paul Krugman, “How Did Economists Get It So Wrong?” The New York Times, September 6, 2009.
10. Eugene Fama and James MacBeth, “Risk, Return, and Equilibrium: Empirical Tests,” Journal of Political Economy 81 (1973): 607–636; see also Eugene Fama, “Efficient Capital Markets: A Review of Theory and Empirical Works,” Journal of Finance 25 (1970): 383–417.
11. See Eugene Fama and Kenneth French, “The Cross Section of Expected Stock Returns,” Journal of Finance 67 (1992): 427–465.
12. See Eric N. Berg, “Market Place: A Study Shakes Confidence in the Volatile-Stock Theory,” The New York Times, February 18, 1992, p. D1.
13. Bill Barnhart, “Professors Say Beta Too Iffy to Trust: A Substitute Stock Scorecard Is Proposed,” Chicago Tribune, July 27, 1992, p. 3.
14. Terence P. Pare, “The Solomon of Stocks Finds a Better Way to Pick Them,” Fortune, June 1, 1992, p. 23.
15. Bill Barnhart, “Professors Say Beta Too Iffy.”
16. Mary Beth Grover, “Slow Growth,” Forbes, October 12, 1992, p. 163.
17. David Dreman, “Bye-Bye to Beta,” Forbes, March 30, 1992, p. 148.
18. Barnhart, “Professors Say Beta Too Iffy.”
19. Eugene F. Fama and Kenneth R. French, “The CAPM Is Wanted Dead or Alive,” Journal of Finance 5, Issue 5 (December 1996): 1947–1958.
20. Ibid.
21. Eugene F. Fama, “Market Efficiency, Long-Term Returns, and Behavioral Finance,” Journal of Financial Economics 49 (1998): 208–306.
22. George M. Frankfurter, “The End of Modern Finance,” Journal of Investing 3, No. 3 (Fall 1994).
23. The impact of beta went far beyond the market. The capital asset pricing model had long been used by corporate managers to determine the attractiveness of new ventures. Because the accepted wisdom holds that companies with higher betas must pay commensurately higher returns, chief financial officers of high-beta companies might be loath to invest in new plants unless they feel they can earn the extra dollop of return. As one business consultant said, “Dethroning the model may have been the best thing that has happened to American business” (Pare, “The Solomon of Stocks”). CAPM, it seems, resulted in bad business decisions in corporate America for a long time.
24. Jonathan Burton, “Revisiting the Capital Asset Pricing Model,” interview with William Sharpe, Dow Jones Asset Manager (May–June 1998): 20–28. Cited with permission.
25. Milton Friedman, “The Methodology of Positive Economics,” in Essays on Positive Economics (Chicago: University of Chicago Press, 1953), p. 15.
26. Fama, “Market Efficiency.”
27. Fama, “Efficient Capital Markets.”
28. EMH thus creates something of a paradox, for if professionals are important to the operation of the efficient market—if they do help to keep price synonymous with value—they must also, according to EMH, be dismal failures in the primary goal of their profession: helping their clients outperform the market.
29. J. Michael Murphy, “Efficient Markets, Index Funds, Illusion, and Reality.”
30. Ibid., p. 10.
31. Michael C. Jensen, “The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (May 1968): 389–416.
32. J. Michael Murphy, “Efficient Markets, Index Funds, Illusion, and Reality.”
33. As indicated, this would exclude a minute number of extraordinarily skilled professionals using extensive resources for only their own benefit.
34. Tim Loughran and Jay Ritter, “The New Issues Puzzle,” Journal of Finance 50, No. 1 (1995): 23–51.
35. Fama and French, “The Cross-Section of Expected Stock Returns.”
36. Burton G. Malkiel, A Random Walk Down Wall Street (New York: Norton, 1973).
37. R. Ball and P. Brown, “An Empirical Evaluation of Accounting Income Numbers,” Journal of Accounting Research 6 (1968): 159–178.
38. V. Bernard and J. Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics 13 (1990): 205.
39. Fama, “Market Efficiency.”
40. Eugene Fama, Lawrence Fisher, Michael Jensen, and Richard Roll, “The Adjustment of Stock Prices to New Information,” International Economic Review 10 (1969): 1–21.
41. See chap. 17 in Contrarian Investment Strategies: The Next Generation for more details and an examination of the chart.
42. David L. Ikenberry, Graeme Rankine, and Earl K. Stice, “What Do Stock Splits Signal?” Journal of Financial and Quantitative Analysis 31, No. 3 (September 1996): 357–375.
43. Hemang Desai and Prem C. Jain, “Long-Run Common Stock Returns Following Stock Splits and Reverse-Splits,” Journal of Business 70 (1997): 409–433.
44. Ray Ball and Philip Brown, “An Empirical Evaluation of Accounting Income Numbers.”
45. Myron S. Scholes, “The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices,” Journal of Business 45 (1972): 179–211.
46. Eugene Fama, “Efficient Capital Markets: II,” Journal of Finance 46 (1991): 1601.
47. Gregor Andrade, Mark Mitchell, and Erik Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15, No. 2 (2001): 103–120; Michael C. Jensen and Richard S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics 11 (1983): 5–50; Gregg A. Jarrell, James A. Brickley, and Jeffry M. Netter, “The Market for Corporate Control: The Empirical Evidence Since 1980,” Journal of Economic Perspectives 2, No. 1 (1998): 49–68.
48. Roni Michaely, Richard H. Thaler, and Kent Womack, “Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?” NBER working paper series no. 4778 (Cambridge: National Bureau of Economic Research, 1994).
49. Victor Bernard and Jacob Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics 13 (1990): 305–340; Victor Bernard and Jacob Thomas, “Post-Earnings-Announcement Drift: Delayed Price Response or Risk Premium?” Journal of Accounting Research 27(S) (1989): 1–36; George Foster, Chris Olsen, and Terry Shevlin, “Earnings Releases, Anomalies, and the Behavior of Security Returns,” Accounting Review 59 (1984): 574–603; Ray Ball and Philip Brown, “An Empirical Evaluation of Accounting Income Numbers.”
50. Jeffery Abarbanell and Victor Bernard, “Tests of Analysts’ Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior,” Journal of Finance 47 (1992): 1181–1206.
51. See, e.g., Tables 11-1 and 12-1.
52. Robert J. Shiller, “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” American Economic Review 71 (1981): 421–436.
53. Ibid., pp. 432–433.
54. Edward M. Saunders, Jr., “Testing the Efficient Market Hypothesis Without Assumptions,” Journal of Portfolio Management (Summer 1994): 28.
55. Karl R. Popper, The Logic of Scientific Discovery (New York: Basic Books, 1959).
56. David N. Dreman, Psychology and the Stock Market (New York: AMACOM, 1977), p. 221.
57. Alfred W. Stonier and Douglas C. Hague, A Textbook of Economic Theory (London: Longmans, Green, 1953), p. 2.
58. Krugman, “How Did Economists Get It So Wrong?”
59. Joseph Stiglitz, “Information and the Change in the Paradigm in Economics,” Nobel Prize lecture, December 8, 2001, pp. 519–520.
60. Tim Icano, “How Did Economists Fail Us So Badly?” The Wall Street Journal, November 30, 2010.
61. John Cassidy, “The Decline of Economics,” The New Yorker, December 2, 1996, pp. 50–60.
62. Ibid.
63. Ibid.
64. Thomas S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1970).
65. Ibid., p. 23.
66. Ibid., p. 52.
CHAPTER 7: WALL STREET’S ADDICTION TO FORECASTING
1. Woody Guthrie, “Pretty Boy Floyd,” Dust Bowl Ballads, 1939, RCA.
2. P. J. Hoffman, P. Slovic, and L. G. Rorer, “An Analysis of Variance Model for the Assessment of Configural Cue Utilization in Clinical Judgment,” Psychological Bulletin 69 (1968): 338–349.
3. These can combine into fifteen possible two-way interactions, twenty possible three-way interactions, fifteen possible four-way interactions, six possible five-way interactions, and one six-way interaction.
4. L. G. Rorer, P. J. Hoffman, B. D. Dickman, and P. Slovic, “Configural Judgments Revealed,” in Proceedings of the 75th Annual Convention of the American Psychological Association 2 (Washington, D.C.: American Psychological Association, 1967), pp. 195–196.
5. Lewis Goldberg, “Simple Models or Simple Processes? Some Research on Clinical Judgments,” American Psychologist 23 (1968): 338–349.
6. Paul Slovic, “Analyzing the Expert Judge: A Descriptive Study of a Stockbroker’s Decision Processes,” Journal of Applied Psychology 53 (August 1969): 225–263; P. Slovic, D. Fleissner, and W. S. Bauman, “Analyzing the Use of Information in Investment Decision Making: A Methodological Proposal,” Journal of Business 45, No. 2 (1972): 283–301.
7. Goldberg, “Simple Models or Simple Processes?”
8. Paul Slovic, “Behavioral Problems Adhering to a Decision Policy,” IGRF Speech, May 1973.
9. Dale Griffin and Amos Tversky, “The Weighing of Evidence and the Determinants of Confidence,” Cognitive Psychology 24 (1992): 411–435; S. Lichtenstein and B. Fischhoff, “Do Those Who Know More Also Know More About How Much They Know? The Calibration of Probability Judgments,” Organizational Behavior and Human Performance 20 (1977): 159–183.
10. W. Wagenaar and G. Keren, “Does the Expert Know? The Reliability of Predictions and Confidence Ratings of Experts,” in Intelligent Decision Support in Process Environments, ed. E. Hollnagel, G. Maneini, and D. Woods (Berlin: Springer, 1986), pp. 87–107.
11. Stewart Oskamp, “Overconfidence in Case Study Judgments,” Journal of Consulting Psychology 29 (1965): 261, 265.
12. L. B. Lusted, A Study of the Efficacy of Diagnostic Radiology Procedures: Final Report on Diagnostic Efficacy (Chicago: Efficacy Study Committee of the American College of Radiology, 1977).
13. J. B. Kidd, “The Utilization of Subjective Probabilities in Production Planning,” Acta Psychologica 34 (1970): 338–347.
14. M. Neal and M. Bazerman, Cognition and Rationality in Negotiation (New York: Free Press, 1990).
15. C. A. S. Stael von Holstein, “Probabilistic Forecasting: An Experiment Related to the Stock Market,” Organizational Behavior and Human Performance 8 (1972): 139–158.
16. S. Lichtenstein, B. Fischhoff, and L. Phillips, “Calibration of Probabilities: The State of the Art to 1980,” in Judgment Under Uncertainty: Heuristics and Biases, ed. D. Kahneman, P. Slovic, and A. Tversky (Cambridge, England: Cambridge University Press, 1982).
17. G. Keren, “Facing Uncertainty in the Game of Bridge: A Calibration Study,” Organizational Behavior and Human Decision Processes 39 (1987): 98–114; D. Hausch, W. Ziemba, and M. Rubenstein, “Efficiency of the Market for Racetrack Betting,” Management Sciences 27 (1981): 1435–1452.
18. J. Frank Yates, Judgment and Decision Making (Englewood Cliffs, N.J.: Prentice-Hall, 1990).
19. Wall Street Transcript 45, No. 13 (September 23, 1974).
20. Herbert Simon, Models of Man: Social and Rational (New York: Wiley, 1970).
21. The belief that all paranoid patients accentuate certain characteristics in their drawings belongs in the category of psychologists’ old wives’ tales.
22. L. Chapman and J. P. Chapman, “Genesis of Popular but Erroneous Psychodiagnostic Observations,” Journal of Abnormal Psychology (1967): 193–204; L. Chapman and J. P. Chapman, “Illusory Correlations as an Obstacle to the Use of Valid Psychodiagnostic Signs,” Journal of Abnormal Psychology (1974): 271–280.
23. Amos Tversky, “The Psychology of Decision Making,” in Behavioral Finance and Decision Theory in Investment Management, ed. A. Wood, ICFA Continuing Education Series (Stanford, Calif.: Stanford University Press, 1995), pp. 2–6.
24. Ibid.
25. Ibid., p. 6.
26. Ibid.
27. Jennifer Francis and Donna Philbrick, “Analysts’ Decisions as Products of a Multi-Task Environment,” Journal of Accounting Research 31 (Autumn 1993): 216–230.
28. A Ph.D. in astrophysics who worked for the Dreman Foundation.
29. For details, please see David N. Dreman, The New Contrarian Investment Strategy (New York: Random House, 1982), app. I, pp. 303–307.
30. “Vanderheiden Choices Top Other Pickers,” The Wall Street Journal, January 3, 1994, p. R34; John R. Dorfman, “‘Value’ Still Has Value, Says This Quartet of Stock Pickers,” The Wall Street Journal, January 4, 1993, p. R8; John R. Dorfman, “Cyclicals Could Be the Right Way to Ride to New Highs in 1992,” The Wall Street Journal, January 2, 1992, p. R24; John R. Dorfman, “New Year’s Stock Advice in an Icy Economy: Insulate,” The Wall Street Journal, January 2, 1991, p. R22; John R. Dorfman, “The Sweet Smell of Success Might Be One of Caution,” The Wall Street Journal, January 2, 1990, p. R6; John R. Dorfman, “Champion Stock-Picker Is Facing 3 Challengers for Title,” The Wall Street Journal, January 3, 1989, p. R6; John R. Dorfman, “Four Investment Advisors Share Their Favorite Stock Picks for 1988,” The Wall Street Journal, January 4, 1988, p. 6B; John R. Dorfman, “Stock Pickers Nominate Big Gainers for 1987,” The Wall Street Journal, January 2, 1987, p. 4B; Rhonda L. Rundle, “Stock Pickers Make Their Picks Public, Betting on Low Inflation, Falling Rates,” The Wall Street Journal, January 2, 1986, p. R4.
31. Just as the theory holds that even professionals cannot outdo the market over time, it also holds that they cannot do substantially worse. After all, it is their very decision making that keeps prices at the proper level in the first place. The surveys, however, give us a different picture from the one assumed by the theorists. The massive underperformance in both up and down markets indicates that their most crucial assumption is inconsistent with a significant body of evidence. The hypothesis is made of straw.
CHAPTER 8: HOW BIG A LONG SHOT WILL YOU PLAY?
1. Ben White, “On Wall Street, Stock Doublespeak; Public, Private Talk at Odds, Papers Show,” The Washington Post, April 30, 2003, p. E01.
2. Gretchen Morgenson, “Bullish Analyst of Tech Stocks Quits Salomon,” The New York Times, August 16, 2002.
3. “The Superstar Analysts,” Financial World, November 1980, p. 16.
4. Ibid.
5. Ibid.
6. David Dreman, “Cloudy Crystal Balls,” Forbes, Vol. 154, Issue 8, October 10, 1994, p. 154; David Dreman, “Chronically Cloudy Crystal Balls,” Forbes, Vol. 152, Issue 8, October 11, 1993, p. 178; David Dreman, “Flawed Forecasts,” Forbes, Vol. 148, Issue 13, December 9, 1991, p. 342; David Dreman, “Hard to Forecast,” Barron’s, March 3, 1980, p. 9; David Dreman, “Tricky Forecasts,” Barron’s, July 24, 1978, pp. 4–5, 16, 18; David Dreman, “The Value of Financial Forecasting: A Contrarian’s Approach,” speech at Fortieth Annual Meeting of the American Financial Association, December 29, 1981. In June 1996, the study was updated again in collaboration with Eric Lufkin, formerly of the Dreman Foundation.
7. David Dreman and Michael Berry, “Analyst Forecasting Errors and Their Implications for Security Analysis,” Financial Analysts Journal 51 (May–June 1995): 30–41.
8. The average of the forecasts of the analysts covering the company. Studies have shown that these estimates are reasonably closely bunched.
9. Before the early 1980s, the database used the forecasts of analysts in the Value Line Investment Survey, which normally were very close to consensus forecasts.
10. We used the database of Abel/Noser Corporation, which contains estimates from the leading forecast services: Value Line prior to 1981, Zacks Investment Research beginning in 1981, and I/B/E/S beginning in 1984. The utilized portion of the database includes 500,000 individual estimates. Eric Lufkin, formerly of the Dreman Foundation, updated the findings for the 1991–1996 period using Abel/Noser Corporation data through 1993Q3 and I/B/E/S estimates thereafter. Thomson First Call provided the data for 1997–2010.
11. The four separate error metrics:
SURPE =(Actual earnings – Forecast) / |Actual earnings|
SURPF =(Actual earnings – Forecast) / |Forecast|
SURP8 =(Actual earnings – Forecast) / Standard deviation of actual earnings, eight quarters trailing
SURPC7 =(Actual earnings – Forecast) / Standard deviation of change in actual earnings, seven quarters trailing.
All the results in the book are for SURPE: forecast error divided by actual earnings.
12. With signs removed. We recorded a total of 189,158 surprises in expansions (104,538 positive and 69,411 negative) and 36,901 surprises in recessions (19,477 positive and 14,941 negative). Note that positive surprises outnumbered negative surprises in both expansions and recessions. Surprises of zero, although not true surprises, have been retained in calculations of all surprises, because they count in assessing analysts’ overall accuracy.
13. Dov Fried and Dan Givoly, “Financial Analysts’ Forecasts of Earnings: A Better Surrogate for Market Expectations,” Journal of Accounting and Economics 4 (1982): 85–107; Patricia C. O’Brien, “Analysts’ Forecasts as Earnings Expectations,” Journal of Accounting and Economics 10 (1988): 53–83; K. C. Butler and L. H. Lang, “The Forecast Accuracy of Individual Analysts: Evidence of Systematic Optimism and Pessimism,” Journal of Accounting Research 29 (1991): 150–156; M. R. Clayman and R. A. Schwartz, “Falling in Love Again: Analysts’ Estimates and Reality,” Financial Analysts Journal (September–October 1994): 66–68; A. Ali, A. Klein, and J. Rosenfeld, “Analysts’ Use of Information About Permanent and Transitory Earnings Components in Forecasting Annual EPS,” Accounting Review 87 (1992): 183–198; L. Brown, “Analysts’ Forecasting Errors and Their Implications for Security Analysis: An Alternative Perspective,” Financial Analysts Journal (January–February 1996): 40–47.
14. J. G. Cragg and B. Malkiel, “The Consensus and Accuracy of Some Predictions of the Growth of Corporate Earnings,” Journal of Finance 23 (March 1968): 67–84.
15. Ibid. You may recall the Meehl studies of clinical psychologists, where it was shown that simple mechanical techniques performed as well as or better than the complex analytical diagnoses in twenty separate studies of trained psychologists. In fact, mechanical prediction formulas have been suggested in a number of fields, primarily psychology, as a direct result of these problems, and they will be a part of the strategies proposed in the following chapters.
16. I. M. D. Little, “Higgledy Piggledy Growth,” Bulletin of the Oxford University Institute of Economics and Statistics (November 1962): 31.
17. I. M. D. Little and A. C. Rayner, Higgledy Piggledy Growth Again (Oxford: Basil Blackwell, 1966).
18. See, e.g., Joseph Murray, Jr., “Relative Growth in Earnings per Share—Past and Future,” Financial Analysts Journal 22 (November–December 1966): 73–76.
19. Richard A. Brealey, An Introduction to Risk and Return from Common Stocks (Cambridge, Mass.: MIT Press, 1968).
20. François Degeorge, Jayendu Patel, and Richard Zeckhauser, “Earnings Management to Exceed Thresholds,” Journal of Business 72, no. 1 (January 1999): 1–33.
21. John Dorfman, “Analysts Devote More Time to Selling as Firms Keep Scorecard on Performance,” The Wall Street Journal, October 29, 1991, p. C1.
22. Ibid. See also Amitabh Dugar and Siva Nathan, “Analysts’ Research Reports: Caveat Emptor,” Journal of Investing 5 (Winter 1996): 13–22.
23. Michael Siconolfi, “Incredible Buys: Many Companies Press Analysts to Steer Clear of Negative Ratings,” The Wall Street Journal, July 19, 1995, p. A1.
24. Ibid., p. 3; Debbie Gallant, “The Hazards of Negative Research Reports,” Institutional Investor (July 1990): 73–80.
25. Siconolfi, “Incredible Buys.”
26. E. S. Browning, “Please Don’t Talk to the Bearish Analyst,” The Wall Street Journal, May 2, 1995, p. C1.
27. Dugar and Nathan, “Analysts’ Research Reports.”
28. Siconolfi, “Incredible Buys.”
29. Ibid.
30. D. Kahneman and A. Tversky, “On the Psychology of Prediction,” Psychological Review 80 (1973): 237–251.
31. D. Kahneman and D. Lovallo, “Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking,” Management Science 39 (January 1993): 1–16.
32. E. Merrow, K. Phillips, and C. Myers, Understanding Cost Growth and Performance Shortfalls in Pioneer Process Plants (Santa Barbara, Calif.: Rand Corporation, 1981).
33. J. Arnold, “Assessing Capital Risk: You Can’t Be Too Conservative,” Harvard Business Review 64 (1986): 113–121.
CHAPTER 9: NASTY SURPRISES AND NEUROECONOMICS
1. For greater detail, see David Dreman, “Don’t Count on Those Earnings Forecasts,” Forbes, Vol. 161, Issue 2, January 26, 1998, p. 110; David Dreman and Michael Berry, “Overreaction, Underreaction, and the Low-P/E Effect,” Financial Analysts Journal 51 (July–August 1995): 21–30; David Dreman, “Nasty Surprises,” Forbes, July 19, 1993, p. 246.
2. We formed the portfolios at the beginning of the first quarter and measured earnings surprises thereafter.
3. Compustat, provided by Standard & Poor’s, is one of the largest stock databases available, giving price, earnings, and other information on more than 34,000 stocks. The studies reported here use the largest 1,500 companies in the Compustat database traded on the NYSE, AMEX, and NASDAQ exchanges, as measured by the total market value of all shares outstanding at the beginning of each calendar year. (This sample is referred to here as the Compustat 1500.) We use the Compustat database for all price and accounting information.
4. To control for negative earnings, we delete companies with no earnings or negative earnings. We also delete P/E multiples above 45 (over 75 from 1997 on), to control for stocks with nominal earnings as a result of poor quarters. In doing so, we also unfortunately lose some of the most highly favored issues.
5. Ibbotson® SBBI®, 2011 Classic Yearbook: Market Results for Stocks, Bonds, Bills and Inflation, 1926–2010.
6. Jennifer Francis and Donna Philbrick, “Analysts’ Decisions as Products of a Multi-Task Environment,” Journal of Accounting Research 31 (Autumn 1993): 216–230.
7. The T-statistics show that the probability that these results are just chance is less than 1 in 1,000, often much less.
8. Jeffery Abarbanell and Victor Bernard, “Tests of Analysts’ Overreaction/Underreaction to Earnings Information as an Explanation for Anomalous Stock Price Behavior,” Journal of Finance 47 (July 1992): 1181–1208; V. Bernard and J. K. Thomas, “Evidence That Stock Prices Do Not Fully Reflect the Implications of Current Earnings for Future Earnings,” Journal of Accounting and Economics 13 (1990): 305–340.
9. Eric Lufkin and I came up with findings similar to those of Abarbanell and Bernard. We also discovered that after the surprise quarter, stocks in the high-, low-, and middle-P/E groups (with positive surprises in that quarter) outperformed those stocks in the same groups without positive surprises for the next three quarters. (The same was true for price-to-book-value and price-to-cash-flow measures.) This seems to be caused by additional positive surprises, if the initial surprise was positive—or negative surprises, if the initial surprise was negative—in the three succeeding quarters, again indicating that analysts’ forecasts do not adjust quickly to changing conditions.
10. Jason Zweig, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich (New York: Simon and Schuster, 2007), p. 66.
11. Ibid., p. 64.
12. Ibid.
13. Pammi V. S. Chandrasekhar, C. Monica Capra, Sara Moore, Charles Noussair, and Gregory S. Berns, “Neurobiological Regret and Rejoice Functions for Aversive Outcomes,” NeuroImage 39 (2008): 1472–1484.
14. Wolfram Schultz, Paul Apicella, Eugenio Scarnati, and Tomas Ljungberg, “Neuronal Activity in Monkey Ventral Striatum Related to the Expectation of Reward,” Journal of Neuroscience 12 (1992): 4595–4610.
15. Jason Zweig, “Your Money and Your Brain.”
16. W. Schultz and A. Dickinson, “Neuronal Coding of Prediction Errors,” Annual Review of Neuroscience 23 (2000): 473–500.
17. Chandrasekhar et al., “Neurobiological Regret and Rejoice Functions,” p. 1479.
18. Ibid. Though the fMRI has not yet been used on earnings surprise, dozens of similar tests have been done with parallel results in many areas, including finance, to investigate the neural correlates of regret and rejoice, disappointment and elation.
19. Zweig, “Your Money and Your Brain.”
20. Schultz and Dickinson, “Neuronal Coding of Prediction Errors.”
21. Chandrasekhar et al., “Neurobiological Regret and Rejoice Functions.”
CHAPTER 10: A POWERFUL CONTRARIAN APPROACH TO PROFITS
1. Francis Nicholson, “Price-Earnings Ratios in Relation to Investment Results,” Financial Analysts Journal 24, No. 1 (January–February 1968): 105–109.
2. Francis Nicholson, in an earlier test that eliminated companies with nominal earnings, measured the performance of high- and low-P/E stocks in the chemicals industry between 1937 and 1954. The results strongly favored the low-P/E stocks. James McWilliams used a sample of nine hundred stocks from the S&P Compustat tapes in the 1953–1964 period and found strong corroboration of the better performance of low-P/E stocks. McWilliams further discovered that although stocks having the highest individual appreciation in any given year appeared to be randomly distributed, those with the greatest declines were in the high-P/E group. William Breen used the 1,400 companies on the Compustat tapes for the 1953–1966 period. He eliminated all stocks with less than 10 percent earnings growth and then set up portfolios of ten stocks with the lowest P/Es relative to the market, comparing them with a series of randomly selected portfolios of ten stocks in each year. See Francis Nicholson, “Price/Earnings Ratios,” Financial Analysts Journal 16 (July–August 1960): 43–45; James D. McWilliams, “Prices and Price-Earnings Ratios,” Financial Analysts Journal 22 (May–June 1966): 137–142; William Breen, “Low Price/Earnings Ratios and Industry Relatives,” Financial Analysts Journal 24 (July–August 1968): 125–127.
3. See Table 7-3, “A Workable Investment Strategy,” in David Dreman, Contrarian Investment Strategies: The Next Generation (New York: Simon and Schuster, 1998), p. 147.
4. David Dreman, “A Strategy for All Seasons,” Forbes, July 14, 1986, p. 118.
5. David Dreman, “Getting Ready for the Rebound,” Forbes, July 23, 1990, p. 376.
6. We used the same methodology in all my studies, as is outlined in chapter 11.
7. David Dreman, “Cashing In,” Forbes, June 16, 1986, p. 184.
8. Within the experimental design, we adjusted for methodological criticisms of previous studies, such as hindsight bias—selecting stocks, as Nicholson did, that had survived to 1962, something an investor of 1937 could not have known—and not using year-end earnings and prices, as previous studies did, when investors could not know earnings until several months later. I did not think those would markedly change the results, and our findings indicate that they didn’t.
9. Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Markets Hypothesis,” Journal of Finance 32 (June 1977): 663–682; Sanjoy Basu, “The Effect of Earnings Yield on Assessments of the Association Between Annual Accounting Income Numbers and Security Prices,” Accounting Review 53 (July 1978): 599–625; Sanjoy Basu, “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks: Further Evidence,” Journal of Financial Economics 12 (June 1983): 129–156.
10. Basu, “Investment Performance of Common Stocks.”
11. B. Rosenberg, K. Reid, and R. Lanstein, “Persuasive Evidence of Market Inefficiency,” Journal of Portfolio Management 13 (1985): 9–17; Dennis Stattman, “Book Values and Stock Returns,” Chicago MBA: A Journal of Selected Papers 4 (1980): 25–45.
12. Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” Journal of Finance 47 (June 1992): 427–465.
13. Ray Ball, “Anomalies in Relationships Between Securities’ Yields and Yield-Surrogates,” Journal of Financial Economics 6 (1978): 103–126.
14. Fama and French, “The Cross-Section of Expected Stock Returns.”
15. Terence Pare, “The Solomon of Stocks Finds a Better Way to Pick Them,” Fortune, June 1, 1992, p. 23.
16. J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk,” Journal of Finance 49 (December 1994): 1541–1578.
17. D. G. MacGregor, P. Slovic, D. Dreman, and M. Berry, “Imagery, Affect and Financial Judgment,” Decision Research Report 97-11 (Eugene, Ore., 1997).
CHAPTER 11: PROFITING FROM INVESTORS’ OVERREACTIONS
1. “Investors Lack Exposure to Contrarian Value Investing Strategies,” presentation given to David Dreman of Dreman Value Management, LLC, by DWS Scudder Deutsche Bank Group. Sources: Deutsche Asset Management, Inc., and Morningstar, Inc., 2006.
2. Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios,” Journal of Finance 32, No. 3 (June 1977): 663–682.
3. Werner F. M. De Bondt and Richard Thaler, “Does the Stock Market Overreact?” Journal of Finance (July 1985): 793–805.
4. The original investor overreaction hypothesis was updated in David Dreman and Michael Berry, “Overreaction, Underreaction and the Low P/E Effect,” Financial Analysts Journal (July–August 1995): 21–30.
5. David N. Dreman and Eric A. Lufkin. “Investor Overreaction: Evidence That Its Basis Is Psychological,” Journal of Psychology and Financial Markets 1, No. 1 (2000): 61–75.
6. For an overview of standard risk-return models, see Zvi Bodie, Alex Kane, and Alan Marcus, Investments, 9th ed. (New York: McGraw-Hill/Irwin, 2010).
7. The Compustat database comprises most of the major companies traded in this country, as well as some hundreds of ADRs traded abroad.
8. The methodology is identical to that in our study described in chapter 9, page 219.
9. Back in Graham’s time, investors used actual book value to price, whereas today most contemporary investors use relative book value, the book value of the company relative to its industry or the market. The reason is that with inflation increasing prices manyfold in the post–World War II period, the replacement costs of land, plant, and equipment are substantially higher than the values shown on most corporate balance sheets. The average company in the S&P 500 currently trades at 1.9 times its book value.
10. Although not shown in the chart, all three strategies continue to outperform for up to ten years. For those of a statistical bent, the t-tests are also high. For example, low P/E has only a 1 in 200 probability of being pure chance, low price to cash flow has 1 in 200, and price to book has 1 in 100. With the best stocks by each value measurement, the probability is 1 in 20. The t-tests are generally weaker on the high-P/E side, but 1 in 20 (the “95 percent confidence level”) is generally considered the basic threshold for significance.
11. Financial studies have indicated that well-diversified portfolios of as few as sixteen stocks have an excellent chance of replicating approximately 85 percent to 90 percent of the return of the group from which they are selected, even if the group is the stock market as a whole.
12. The large-company rule is not etched in stone, however. As chap. 15 of Contrarian Investment Strategies: The Next Generation (1998) demonstrates, small contrarian companies provide somewhat higher returns over time than their larger siblings. But the small-cap strategy is entirely different and requires substantial resources to implement properly. It should normally be used for only a relatively small portion of your stock portfolio.
13. Andrew Ross Sorkin and Landon Thomas, Jr., “J.P. Morgan Acts to Buy Bear Stearns at Huge Discount,” The New York Times, March 16, 2008.
14. Robin Sidel, David Enrich, and Dan Fitzpatrick, “WaMu Is Seized, Sold Off to J.P. Morgan, in Largest Failure in U.S. Banking History,” The Wall Street Journal, September 26, 2008.
15. David Ellis and Jeanne Sahadi, “JPMorgan to Buy WaMu,” CNN Money, September 26, 2008.
16. See the performance of contrarian strategies including bear markets in chapter 10. In The New Contrarian Investment Strategy, I gave a similar record of performance from the 1976–1982 period, one of moderate market decline. The approach significantly outperformed the S&P 500 during that earlier period, too.
17. The results are taken from the twenty-seven-year study from 1970 to 1996 that I did in collaboration with Eric Lufkin, which I have updated through 2010.
18. Other studies over sixty years come up with similar results.
19. This is for one quarter. For one year, there would be twenty-five draws with the card returned to the deck.
20. The numbers are startling but true. To follow up, we did a Monte Carlo simulation with 100,000 trials. Low P/E won 99,891 times.
CHAPTER 12: CONTRARIAN STRATEGIES WITHIN INDUSTRIES
1. This work is based in part on an exchange of ideas between Sanjoy Basu and myself. Basu produced preliminary results that, unfortunately, were lost after his untimely death in 1983.
2. The previous literature on whether contrarian strategies worked included William Breen, “Low Price-Earnings Ratios and Industry Relatives,” Financial Analysts Journal (July–August, 1968): 125–127. Breen analyzed low-P/E stocks for one-year periods between 1953 and 1966. He found that stocks with low absolute P/E did only slightly better than stocks with the lowest P/E in an industry. However, the test used extremely small samples of ten stocks each. R. Fuller, L. Huberts, and M. Levinson, “Returns to E/P Strategies, Higgledy-Piggledy Growth, Analysts’ Forecast Errors, and Omitted Risk Factors,” Journal of Portfolio Management (Winter 1993): 13–24, found that low P/Es within industries outperform the market.
3. The original study by Eric Lufkin and me covered the period 1973–1996. We used a government industry classification system that was discontinued in the late 1990s. The industry taxonomy developed by Standard & Poor’s and Morgan Stanley Capital International called Global Industry Classification Standard (GICS) classifies industries more accurately for financial use. Reliable historical data for the newer classification start in 1995.
4. The industries that had the largest numbers of the absolutely cheapest stocks only marginally outperformed the averages, with returns well below those gained by the industry-relative strategy.
5. Benjamin Graham, David Dodd, Sidney Cottle, and Charles Tatham, Security Analysis, 4th ed. (New York: McGraw-Hill, 1962), p. 179.
6. Since I use large-cap companies in this strategy, the reader would be shielded from the frenetic small-cap concept stocks and IPOs, which were not a part of our study and which I doubt would come close to these results.
CHAPTER 13: INVESTING IN A NEW, ALIEN WORLD
1. Rob Iati, “The Real Story of Trading Software Espionage,” Advanced Trading, July 10, 2009. Online at http://www.advancedtrading.com/algorithms/218401501.
2. Kambiz Foroohar, “Trading Pennies into $7 Billion Drives High-Frequency’s Cowboys,” Bloomberg, October 6, 2010.
3. Jim McTague, “The Real Flash-Crash Culprits,” Barron’s, October 9, 2010. Online at http://online.barrons.com/article/58500042405.html.
4. “Preliminary Findings Regarding the Market Events of May 6, 2010—Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues—May 18, 2010,” p. 65.
5. Ibid.
6. Foroohar, “Trading Pennies into $7 Billion.”
7. Whitney Kisling, “Fund Outflows Top Lehman at $75 Billion,” Bloomberg, September 19, 2011.
8. Tom Lauricella, “Pivot Point: Investors Lose Faith in Stocks,” The Wall Street Journal, September 26, 2011.
9. Jenny Strasburg, “A Wild Ride to Profits,” The Wall Street Journal, August 16, 2011.
10. Nina Mehta, “High-Frequency Firms Tripled Trades Amid Rout, Wedbush Says,” Bloomberg, August 12, 2011.
11. CNBC, Fast Money, August 8, 2011.
12. Kevin Drawbaugh, “SEC Head Eyes Fast Traders on Crash Anniversary,” Reuters, May 6, 2011.
13. Jenny Strasburg and Jean Eaglesham, “Subpoenas Go Out to High-Speed Trade Firms,” The Wall Street Journal, August 8, 2011.
14. Mehta, “High-Frequency Firms Tripled Trades Amid Rout, Wedbush Says.”
15. Tim Cave, “European Regulator Moves to Limit High-Speed Trading,” Financial News, July 21, 2011.
16. Jacob Bunge and Brendan Conway, “Regulators Hone Circuit-Breaker Proposals,” The Wall Street Journal, September 28, 2011.
17. The record of these mutual funds can be found in the Forbes 2010 Mutual Fund Guide. Similar information on no-load funds can be found on Lipper, Morningstar, or Barron’s.
CHAPTER 14: TOWARD A BETTER THEORY OF RISK
1. Frank H. Knight, Risk, Uncertainty, and Profit, Hart, Schaffner, and Marx Prize Essays, No. 31 (Boston and New York: Houghton Mifflin, 1921):
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term “risk,” as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. . . . The essential fact is that “risk” means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. . . . It will appear that a measurable uncertainty, or “risk” proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We . . . accordingly restrict the term “uncertainty” to cases of the non-quantitative type.
2. Jeremy J. Siegel, Stocks for the Long Term (New York: Irwin), 1994.
3. FDIC, Trust Examination Manual, section 3, “Asset Management,” Part 1, “Investment, Principles, Policies and Products.”
4. Ibbotson® SBBT®, 2011 Classic Yearbook: Market Results for Stocks, Bonds, Bills and Inflation for 1926–2010. Growth of $100,000 for long-term government bonds adjusted for inflation from 1946 to 2010.
5. Tax Foundation, “Federal Individual Income Tax Rates History,” www.taxfoundation.org/files/fed_individual_rate_history-20110323.pdf.
6. An earlier version of this chart is found in David Dreman, Contrarian Investment Strategies: The Next Generation (New York: Simon and Schuster, 1998), p. 314.
CHAPTER 15: THEY’RE GAMBLING WITH YOUR MONEY
1. David Dreman, “Bailout Blues,” Forbes, Vol. 182, Issue 10, November 17, 2008, p. 136.
2. Frank Partnoy, “The Case Against Alan Greenspan,” Euromoney Institutional Investor, September 1, 2005, p. 2.
3. Lucette Lagnado, “After the Bubble, Beauty Is But Fleeting for Greenspan Portraits,” The Wall Street Journal, February 19, 2010.
4. Alex MacCallum, “Want Alan Greenspan to Come to Dinner? That’ll Be $250,000,” Huffington Post, March 28, 2008.
5. Partnoy, “The Case Against Alan Greenspan.”
6. “The Tragedy of Robert Rubin, the Fall of Citigroup, and the Financial Crisis—Continued,” The Strange Death of Liberal America, November 30, 2008, http://thestrangedeathofliberalamerica.com/the-tragedy-of-robert-rubin-the-fall-of-citigroup-and-the-financial-crisis-continued.html.
7. Peter S. Goodman, “Taking a Hard Look at a Greenspan Legacy,” The New York Times, October 9, 2008.
8. Marshall Auerback, “Robert Rubin Is Back: Noooooo!!!” Business Insider, January 5, 2010.
9. Robert Scheer, “The Rubin Con Goes On,” The Nation, August 11, 2010.
10. Ibid.
11. Goodman, “Taking a Hard New Look at a Greenspan Legacy.”
12. Ibid.
13. Ibid.
14. Ibid.
15. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime Mortgage Market,” Federal Reserve Bank of St. Louis Review (January–February 2006): 38.
16. Board of Governors of the Federal Reserve System, “20-Year Treasury Constant Maturity Rate,” May 31, 2011, www.federalreserve.gov/releases/h15/current/h15.pdf.
17. “Residential MBS Insurance,” Inside MBS and ABS, LoanPerformance, Amherst Securities, 2010.
18. “Characteristics and Performance of Nonprime Mortgages” (Washington, D.C.: United States Government Accountability Office, July 28, 2009).
19. SEC Press Release, “Former Countrywide CEO Angelo Mozilo to Pay SEC’s Largest-Ever Financial Penalty Against a Public Company’s Senior Executive,” October 15, 2010, www.sec.gov/news/press/2010/2010-197.htm.
20. Peter Ryan and Kym Landers, “I Didn’t See the Subprime Crisis Coming: Greenspan,” ABC News, September 17, 2007.
21. I. P. Greg, James R. Hagert, and Jonathan Karp, “Housing Bust Fuels Blame Game,” The Wall Street Journal, February 27, 2008.
22. Jeremy W. Peters, “Fed Chief Addresses Foreclosures,” The New York Times, May 18, 2007.
23. “The Economic Outlook,” testimony by chairman Ben S. Bernanke before the Joint Economic Committee, U.S. Congress, March 28, 2009.
24. Ibid.
25. Guy Rolnik, interview with Nobel laureate Daniel Kahneman, “Irrational Everything,” Haaretz, April 10, 2009.
26. Maurice Marwood, “That’s Where the Money Is,” Nassau Institute, January 18, 2004.
27. “Opening Remarks of Chairman Phil Angelides at the Financial Crisis Inquiry Commission Hearing on the Credibility of Credit Ratings,” June 2, 2010.
28. Zeke Faux and Jody Shenn, “Subprime Mortgage Bonds Getting AAA Rating S&P Denies to U.S. Treasuries,” Bloomberg Businessweek, August 31, 2011.
29. United States Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, “Exhibits: Hearing on Wall Street and the Financial Crisis—The Role of Investment Banks,” Exhibit 105, e-mail from Tom Montag to Daniel L. Sparks, Washington, D.C., April 27, 2010.
30. Christine Harper and David Voreacos, “Goldman Sachs Chief Blankfein Hires Attorney Weingarten for Probe by U.S.,” Bloomberg Businessweek, August 22, 2011.
CHAPTER 16: THE NOT-SO-INVISIBLE HAND
1. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London: W. Strahan and T. Cadell, 1776), Vol. 1, p. 349.
2. Ibid., p. 43.
3. T. G. Buchholz, New Ideas from Dead Economists: An Introduction to Modern Economic Thought (London: Penguin, 1999), p. 17.
4. David Ricardo, On the Principles of Political Economy and Taxation (London: John Murray, 1817).
5. Ibid.
6. John Harwood, “53% in US Say Free Trade Hurts Nation: NBC/WSJ Poll,” CNBC, September 28, 2010.
7. Paul R. Krugman, “Is Free Trade Passé?” Journal of Economic Perspectives 1, No. 2 (1987): 131–144.
8. Ministry of Labour and State Statistical Bureau, “(DA) Labour-Related Establishment Survey.” Survey. Laborsta Internet. ILO Department of Statistics. <http://laborsta.ilo.org> Midyear exchange rate was used to derive figures.
9. David Barboza, Christopher Drew, and Steve Lohr, “G.E. to Share Jet Technology with China in New Joint Venture,” The New York Times, January 17, 2011.
10. Mark Lee and Bruce Einhorn, “Microsoft’s Ballmer Says China Piracy Makes India a Better Bet,” Bloomberg, May 25, 2010.
11. Ibid.
12. Shaun Rein, “Piracy from China: How Microsoft, Ralph Lauren, Nike and Others Can Cope,” Seeking Alpha, April 9, 2007.
13. “Trade in Goods with China,” U.S. Census Bureau: Foreign Trade, revised June 2009, 2011. Online at http://www.census.gov/foreign-trade/balance/c5700.html.
14. Senator Carl Levin at Congressional Executive China Commission Hearing, “Will China Protect Intellectual Property? New Developments in Counterfeiting, Piracy and Forced Technology Transfer,” September 22, 2010.
15. Wayne M. Morrison, “China-U.S. Trade Issues,” Congressional Research Service, CRS Report for Congress, January 7, 2011, p. 2.
16. Catherine Rampell, “Second Recession in U.S. Could be Worst Than First,” The New York Times, August 7, 2011.
17. Grail Research, “Global Financial Crisis: Bailout/Stimulus Tracker,” September 12, 2009. Stimulus announced by respective governments.
18. Jeannine Aversa, “Bernanke Hits Back at Critics of Bond-Buying Plan,” Washington Associated Press, November 19, 2010.
19. Ibid.
20. Benjamin Graham and David L. Dodd, Security Analysis: Principles and Technique (New York: McGraw-Hill, 2005).
21. Richard J. Whalen, “Joseph P. Kennedy: A Portrait of the Founder,” Fortune, April 10, 2011.