Stocks for the Long Run : the Definitive Guide to Financial Market Returns and Long-term Investment Strategies

Out-of-Favor Stocks and the Dow 10 Strategy

Dave:Can you use contrarian strategy to pick individual stocks?

IC:Yes. Contrarians believe that the swings of optimism and pessimism

infect individual stocks as well as the overall markets. Therefore, buying

out-of-favor stocks can be a winning strategy.

Werner De Bondt and Richard Thaler examined portfolios of both

past stock winners and losers to see if investors became overly opti-

mistic or pessimistic about future returns from studying the returns of

the recent past.^31 Portfolios of winning and losing stocks were analyzed

CHAPTER 19 Behavioral Finance and the Psychology of Investing 335

TABLE 19–1

Investor Confidence and Subsequent Dow Price Returns: Sentiment = Bull/(Bull + Bear)

Bull and Bear from Investors Intelligence, New Rochelle, New York

(January 2, 1970 - June 2, 2006)

Sentiment Frequency Three Month Six Month Nine Month Twelve Month

0.2 - 0.3 1.14% 18.52% 15.40% 22.79% 20.74%

0.3 - 0.4 8.34% 12.24% 13.79% 16.52% 15.82%

0.4 - 0.5 15.28% 20.30% 15.02% 13.06% 13.43%

0.5 - 0.6 27.29% 15.98% 13.61% 11.10% 10.21%

0.6 - 0.7 27.60% 8.61% 6.75% 6.66% 6.03%

0.7 - 0.8 15.95% 10.45% 7.17% 7.03% 6.74%

0.8 - 0.9 3.83% -0.39% 0.23% -3.32% -1.79%

0.9 - 1.0 0.57% 0.35% -3.87% -9.17% -10.18%

Overall 100.00% 12.72% 10.35% 9.45% 9.02%

Sentiment Frequency Three Month Six Month Nine Month Twelve Month

.30 - .35 1.28% 20.43% 15.83% 15.51% 20.66%

.35 - .40 3.27% 16.69% 18.19% 18.63% 20.85%

.40 - .45 4.78% 30.10% 22.52% 20.99% 21.24%

.45 - .50 7.12% 33.39% 18.61% 15.25% 15.24%

.50 - .55 15.17% 21.80% 17.98% 15.74% 14.81%

.55 - .60 17.97% 12.92% 11.61% 11.36% 11.05%

.60 - .65 24.85% 4.65% 5.67% 6.91% 6.25%

.65 - .70 14.35% 5.37% 5.34% 4.38% 5.35%

.70 - .75 8.63% 10.64% 7.04% 6.63% 6.43%

.75 - .80 2.57% 3.03% 6.86% 4.51% 5.02%

Overall 100.00% 13.19% 11.04% 10.38% 10.33%

1990 - 2006 Annualized Returns Subsequent to Sentiment Readings

1970 - 2006

Annualized Returns Subsequent to Sentiment Readings

(^31) Werner F. M. De Bondt and Richard H. Thaler, “Does the Stock Market Overreact?” Journal of Fi-
nance, vol. 49, no. 3 (1985), pp. 793–805.