The Long View
David Dreman, a regular columnist for Forbes magazine and well-known for his contrarian views on investing, is the subject of an interesting article appearing in the June, 2006 edition of Smart Money magazine, starting on page 46.
According to Dreman, investors tend to make the same mistakes again and again and when they do, he stands ready to profit.
He talks about heuristics, which are simple guidelines that we use without thinking. We need them to operate and they work very well most of the time. Heuristics allow people to concentrate on what's important at that moment, but they don't work when people aren't good statistical processors.
Then he talks about the base rate and the case rate. For stocks, the base rate is the long view - the 10 percent the stock market has returned on average over decades. The case rate is what the market's been doing for a few weeks or months or even a couple of years. So when we get a bubble like we had in the late 1990s, people immediately go over to the case rate - the short-term return - and project that into the future forever. So they end up paying too much for their stocks.
There is a second part to this. Mistaking the case rate for the base rate is a processing error. But there's another piece to it, and that's affect. Affect is based on likes and dislikes. The more we like [a stock], the more we're willing to pay for it. The less we like it, obviously, the less we're willing to pay for it. Research has shown that if we like something, we can overvalue it by as much as 100 times its true worth. And bingo - there's your bubble!
...There is more to the article and I highly recommend getting your hands on this issue of Smart Money and paying attention to the wisdom of David Dreman.
* * * * *
According to Dreman, investors tend to make the same mistakes again and again and when they do, he stands ready to profit.
He talks about heuristics, which are simple guidelines that we use without thinking. We need them to operate and they work very well most of the time. Heuristics allow people to concentrate on what's important at that moment, but they don't work when people aren't good statistical processors.
Then he talks about the base rate and the case rate. For stocks, the base rate is the long view - the 10 percent the stock market has returned on average over decades. The case rate is what the market's been doing for a few weeks or months or even a couple of years. So when we get a bubble like we had in the late 1990s, people immediately go over to the case rate - the short-term return - and project that into the future forever. So they end up paying too much for their stocks.
There is a second part to this. Mistaking the case rate for the base rate is a processing error. But there's another piece to it, and that's affect. Affect is based on likes and dislikes. The more we like [a stock], the more we're willing to pay for it. The less we like it, obviously, the less we're willing to pay for it. Research has shown that if we like something, we can overvalue it by as much as 100 times its true worth. And bingo - there's your bubble!
...There is more to the article and I highly recommend getting your hands on this issue of Smart Money and paying attention to the wisdom of David Dreman.
* * * * *
posted by Bob Moser at
6:25 PM
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