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seen portfolios loaded with dozens of companies that look good on paper but that have long been dogs in the market, resulting in poor returns.

Again, there are many partial answers to this problem, but I think 2J4 to 3 years is an adequate waiting period. (For a cyclical stock with a drop in eamings, this might be stretched to three-and-a-half years.) If after that time the stock still disappoints, sell it. John Templeton, one of the masters of value investing, used a six-year time span. You be the judge, but stick to your time frame and dont be stubborn.

Another important mle is to sell a stock immediately if the long-term fundamentals deteriorate significantly. No matter how painstaking the research, something can go wrong, worsening a companys or an industrys outlook dramatically. Im not talking about a poor quarter or a temporary 8 18 that a stock will snap back from, but major changes that weaken a companys prospects. Under these conditions, I have found that taking your lumps immediately and moving on usually results in the smallest loss.

To summarize: dont be stubbom, dont be greedy, and dont be afraid to take small losses. Above all, when you buy a stock, make a mental decision as to the level at which you will sell it-and stick to that decision. You may lose a few points at the top, but youll make a lot more than youll lose in the long mn.

A further question may arise with sell strategies using the eclectic approach. Suppose you have a portfolio of 25 or 30 stocks and find a new one that ranks much higher by our indicators, while trading at a lower contrarian ratio than stocks you already own. A switch might then be made, but keep in mind the principle of a fixed number of stocks in the portfolio: each time one is purchased, another one should be sold. Because you are bringing in more judgment in switching, and therefore more opportunity for error, changes of this sort should be relatively rare in order to avoid the dangers of overtrading. Or, as horse players like to say, "Stay away from the switches."

A supplementary mle is, do not sell a stock that attains a high P/E multiple solely because of a decline in eamings, either through a large one-time charge or because of temporary business conditions. It is tme that by using the contrarian approach you can acquire a number of clinkers that are nearing peak eamings and will incur income declines, whether because they are cyclical or for other reasons. However, we know the Overall superior record of contrarian stocks, which contains numbers of such companies. Thus, if you have adequate diversification, both by the number of stocks and by industry, this should not be a major problem.



Also, the price drop will often be an overreaction to the anticipated decline in eamings. Take the case of Compaq, trading at $9 in early 1991. At the time it was trading at a P/E of \4-under that of the S&P 500. Eamings declined that year by almost 50%, and Compaqs multiple rose above the markets as the stock fell as low as 3!. By the latter part of 1994, however, the stock was over $15, and by late-1997 it had moved up to $79, rising far more than the spurting S&P over this time, while staying at a below-market P/E.

In this chapter, we have looked at the relative-industry contrarian strategy, as well as a number of additional ways to use the other strategies we have developed. We also examined a number of techniques for people with limited capital, and looked at the question of whether you should invest abroad. Next, lets tum to the heart of why contrarian strategies work with such consistency: the predictability of investor overreaction. Armed with this knowledge, we have a far better chance of not stampeding with the herd, whether in euphoria or panic, and have a real possibility of benefiting from the greatest opportunity of all-investing in crisis.



Knowing Your Market Odds

IN THIS section we have seen that investors make systematic errors in predicting which will be the " best" and "worst" stocks. We have also been looking at the strategies and techniques that will allow you to benefit from their mistakes. Now its time to examine why investors, many of whom are highly knowledgeable about markets, go off the deep end time after time. Overreaction is the main reason people make repeated and predictable errors, the linchpin of contrarian strategies

However, investor overreaction is only one way that people repeatedly swing widely away from rational behavior. The psychological pressures we are discussing might also account for such anomalies as soothsayers warnings resulting in the evacuation of London in the early sixteenth century, on the lighter side, and to fans rioting murderously at a soccer game, or to lynchings, on the darker.

We will see in chapter 16 that the most gentle peer pressure can lead us to bad decisions, even when the facts are straightforward and easy to distinguish. But when reality is complex and the situation is hard to read, "social reality"-the consensus of the group, no matter how farfetched-can take a grip on the mind, and tum strong, rational, independent people into sheep. Or, to find a metaphor more appropriate to human beings, lone wolves join the pack and follow anyone who acts like an alpha male.

But the psychological findings on group peer behavior provide only a part of the answer. Investors, even professionals, fall prey to important logical fallacies and psychological failings. Some of the latter are relatively new; others have been known for decades. These psychological pressures impact our decisions under conditions of uncertainty in a very



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