This book is a must read. It is loaded with research, statistics and data. It also talks in detail about the investor psychology. Have given the rules talked about in the book. The rules alone may not have the impact it should have. The points below are just for directing the reader to the book. Even if you do not agree to the points raised in the book, it will definitely give you another perspective to the stock market.
The major thesis of the book is that investors overact to events.
The over valuation of the "best" and the undervaluation of the "worst" stocks often go to the extremes - so much so that their earnings and other surprises affect "best" and "worst" stocks in a diametrically different way.
Betting on well-defined patterns of investor behaviour will give you higher probabilities-strongly backed by statistics-than any other method of investing in use today.
Rule 1: Do not use market-timings or technical analysis. These techniques can only cost you money.
Rule 2: Respect the difficulty of working with mass of information. Few of us can use it successfully. In-depth information does not translate into in-depth profits.
Rule 3: Don't make an investment decision based on correlations. All correlations in the market, whether real or illusory, will shift and soon disappear.
Rule 4: Tread carefully with current investment methods. Our limitations in processing complex information correctly prevent their successful use by most of us.
Rule 5: There is no highly predictable industries which you can count on analysts forecasts. Relying on these estimates will lead to trouble.
Rule 6: Analysts forecasts are usually optimistic. Make the downward adjustment to your earnings estimate.
Rule 7: Most current security analysis requires a precision in analysts estimates that is impossible to provide. Avoid methods that demand this level of accuracy.
Rule 8: It is impossible, in a dynamic economy with constantly changing political, economic, industrial, and competitive conditions, to use the past to estimate the future.
Rule 9: Be realistic about the downside of an investment, recognizing our human tendency to be both overtly optimistic and overly confident. Expect the worst to be much more severe than your initial projection.
Earnings surprises, whether positive or negative, affect favored and out-of-favor stocks very differently. Surprise consistently results in above-average performance for our-of-favor stocks and below-performance for favored stocks
Rule 10: Take advantage of the high rate of analyst forecast errors by simply investing in out-of-favor stocks.
Rule 11: Positive and negative surprises affect "best" and "worst" stocks in a diametrically opposite manner.
Rule 12:
(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.
(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.
(C) Negative surprise result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.
(D) The effect of an earnings surprise continues for an extended period of time.
Rule 13: Favored stocks under perform the market, while the out-of-favor companies outperform the market, but the reappraisal often happens slowly even glacially.
Rule 14: Buy solid companies currently out of market favor, as measured by their low price-to-earnings, price-to-cash flow or price-to-book value ratios, or by their high yields.
Rule 15: Don't speculate on highly priced concept stocks to make above-average returns. The blue-chip stocks that widows and orphans traditionally choose are equally valuable for the more aggressive businessman or woman
Rule 16: Avoid unnecessary trading. The costs can significantly lower your returns over time. Low price-to-value strategies provide well above market returns for years, and are an excellent means of eliminating excessive transaction costs.
Contrarian Stock Selection: A-B-C Rules
Rule 17: Buy only contrarian stocks because of their superior performance characteristics.
Rule 18: Invest equally in 20 to 30 stocks, diversified among 15 or more industries(if your assets are of sufficient size)
Rule 19: Buy medium- or large-sized stocks listed on the New York Stock Exchange, or only larger companies or the American Stock Exchange.
Five fundamental indicators can be used to supplement the three A-B-C rules of contrarian selection
Indicator 1. A Strong financial position
Indicator 2. As many favorable operating and financial ratios as possible
Indicator 3. A higher rate of earnings growth than the S&P 500 in the immediate past, and the likelihood that it will not plummet in the near future.
Indicator 4. Earnings estimates should always lean to the conservative side.
Indicator 5. An above-average dividend yield, which the company can sustain and increase.
These additional methods may not be for every investor, but you should be aware of them, since they represent some of the latest results from research.
Rule 20: Buy the least expensive stocks within an industry, as determined by the four contrarian strategies, regardless of how high or low the general price of the industry group.
Rule 21: Sell a stock when its P/E ratio (or other contrarian indicator) approaches that of the overall market, regardless of how favorable prospects may appear. Replace it with another contrarian stock.
I think 2 1/2 to 3 years is an adequate waiting period. If after that time the stock still disappoints , sell it.
Another important rule is to sell a stock immediately if the long-term fundamentals deteriorate significantly.
To Summarize : don't be stubborn, don't be greedy and don't be afraid to take small losses
Rule 22: Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in markedly different outcome.
Rule 23: Don't be influenced by the short-term record of a money manager,broker,analyst, or advisor, no matter how impressive; don't accept cursory economic or investment news without significant substantiation.
Rule 24: Don't rely solely on the "case rate". Take into account the "base rate" - the prior probabilities of profit or loss
In each instance , the information in the particular case being examined should , where possible , be supplemented by evidence of the long term record of similar situations
Ex. Most buyers of hot ipo in the 1980s and 1990s focussed on the individual story and forgot that 80% of these issues had dropped in price after the 1962 and 1968 market breaks.
Rule 25: Don't be seduced by recent rates of returns for individual stocks or the market when they deviate sharply from past norms(the "case rate"). Long term returns of stocks (the "base rate") are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.
Rule 26: Don't expect the strategy you adopt will provide a quick success in the market; give it a reasonable time to work out.
The Investor Overreaction Hypothesis makes these predictions:
1. "Best" stocks under perform the markets, while "worst" stocks outperform, for long periods.
2. Positive surprises boost "worst" stocks significantly more than they do "best" stocks.
3. Negative surprises knock "best" stocks down much more than "worst" stocks.
4. There are two distinct categories of surprise: event triggers(positive surprises on "worst" stocks, and negative surprises on "best"), and reinforcing events(negative surprises on "worst" stocks and positive surprises on "best"). Event triggers result in much larger price movements than do reinforcing events.
5. The differences will be significantly only in the extreme quantiles, with a minimal impact on the 60% of stocks in the middle.
Rule 27: The push towards an average rate of return is the fundamental principle of competitive markets.
Rule 28: It is far safer to project a continuation of the psychological reaction of investors than it is to project the visibility of the companies themselves.
Crisis Investing
Rule 29: Political and financial crises lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don't sell.
Rule 30: In a crisis, carefully analyze the reasons put forward to support lower stock prices-more often than not they will disintegrate during scrutiny.
Rule 31: (A) Diversify extensively. No matter how cheap a set of stocks looks, you will never know for sure that you aren't getting a clinker.
(B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.
Rule 32: Volatility is not risk. Avoid investment advice based on risk.
Small-Cap Contrarian Rules
Rule 33: Small-cap investing: Buy companies that are strong financially (normally no more than 60% debt in the capital structure for a manufacturing firm)
Rule 34: Small-cap investing: Buy companies with increasing and well-protected dividends that also provide an above-market yield.
Rule 35: Small-cap investing: Pick companies with above-average earnings growth rates.
Rule 36: Small-cap investing: Diversify widely, particularly in small companies, because these issues have far less liquidity. A good portfolio should contain about twice as many stocks as an equivalent large-cap one.
Rule 37: Small-cap investing: Be patient. Nothing works every year, but when smaller caps click, returns are often tremendous.
Rule 38: Small-company trading (e.g.Nasdaq): Don't trade thin issues with large spreads unless you are almost certain you have a big winner.
Rule 39: When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large the total cost will be.
Rule 40: Avoid the small, fast-track mutual funds. The track often ends at the bottom of a cliff.
Psychology and Markets
Rule 41: A given in markets is that perceptions change rapidly
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