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The New Contrarian Investment Strategy, in detail
The New Contrarian Investment Strategy is David Dreman's argument that systematic investor overreaction to both good and bad news creates predictable, persistent mispricings in the stock market that a disciplined contrarian investor can exploit. Published in 1982 and drawing on several years of empirical research, the book predated what became behavioral finance by a decade and offered one of the first systematic, data-supported cases for a value-oriented, low-expectation investing approach.
Dreman's central finding is that stocks with low price-to-earnings ratios — the so-called "out of favor" stocks that analysts and investors have given up on — consistently outperform stocks with high P/E ratios over long time horizons. The explanation he offers is psychological rather than purely financial: investors systematically overestimate the future prospects of glamour stocks (high P/E, high expectations) and underestimate the recovery potential of fallen favorites (low P/E, low expectations). Because expectations are too extreme in both directions, the market regularly delivers positive surprises to low-expectation stocks and disappointments to high-expectation ones.
The psychological mechanism Dreman identifies — which he calls the availability heuristic in investing — is that recent performance, dramatic events, and analyst consensus have disproportionate weight on investor judgment, and that this effect is systematic rather than random. It cannot be arbitraged away by rational investors because the behavioral biases are themselves stable and shared. This anticipates by a decade the more formal treatment of overreaction in the behavioral finance work of De Bondt and Thaler.
The book's practical recommendations are straightforward: buy stocks with low P/E ratios, low price-to-book, or low price-to-cash-flow from sectors currently out of favor, hold them patiently, and resist the narrative pull that makes high-expectation stocks feel like obvious buys. Dreman is specific about time horizons and realistic about the psychological difficulty of maintaining a contrarian position when the consensus is going the other way. Readers should note the book is from 1982 and some sections read as a period document, but the behavioral argument has only accumulated more empirical support since.
The big ideas
- 1.
Low P/E stocks have historically outperformed high P/E stocks over long time horizons, not because investors are irrational but because their rationality is systematically distorted in predictable ways.
- 2.
Investors overreact to both good and bad news, creating excess pessimism about out-of-favor stocks and excess optimism about favored ones. Mean reversion in expectations is what drives contrarian returns.
- 3.
The availability heuristic means recent dramatic events — good earnings, scandals, rapid growth — have disproportionate weight on analyst forecasts and investor sentiment.
