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85

RULE 27

The push toward an average rate of return is a fundamental principle of competitive markets.

Yet it is one that investors never seem to learn. It is also the reason that the superior performance of contrarian stoclcs and the inferior retums of the most pricey stocks are so consistent.

The highly favored stocks and the contrarian cases represent extremes. The probability is high that future retums will be more in line with more average companies. But most investors do not see it this way. Instead, they tend to view the current trend as the norm, no matter how extreme it is within a probability distribution. The consistent overreaction to current trends opens up a great opportunity for the investor- putting you ahead of the crowd, so to speak. Which brings us to an important mle:

RULE 28

It is far safer to project a continuation of the psychological reactions of investors than it is to project the visibility of the companies themselves.

From the prior performance of contrarian stocks we have seen this approach work with remarkable reliability for over 60 years. It is tme, of course, that there are excellent companies that will continue to chalk up above-average growth for years or decades to come, and there are especially talented investors who will find them at reasonable prices. But for most of us, whether individual or expert, the odds of winning at this game are pretty slim.

As I hope it is now apparent, contrarian strategies are powered by investor overreaction. Whether one is buying cheap stocks or junk bonds, the psychological forces are the same. Though it is not yet possible to quantify strategies to markets such as art or real estate, overreaction occurs in them in an identical manner. Investor overreaction is one of the most powerful tools for making money in markets. Lets next look at an outstanding opportunity that overreaction presents-panic in a company, an industry or in the market itself.



PART IV

INVESTING IN THE 2CENTURY



Crisis Investing

In 1956, a young American Congressman wrote Profiles in Courage, a book that dealt with how ten important Americans successfully handled crises. It was a best seller, and catapulted John F. Kennedy into the public eye. People have always been fascinated by how an individual or group soberly faces a crisis and surmounts it, or even turns it to advantage. Crisis, indeed, can clothe a man in glory. In the darkest days of 1940, with France already prostrate under the Nazi heel, and with Britains survival being calculated in weeks, Winston Churchill stood before the House of Commons and uttered the immortal words, "We shall never surrender." In the 1960s, Martin Luther King marched past glowering mobs and police armed with catde prods, believing that only through peaceful confrontation and crisis would civil rights be won.

On the other hand, crisis can clothe us in ignominy. Crisis has always victimized investors-and the walldng wounded are everywhere. Some even seem to carry their scars as a badge of courage, as if surviving terrible losses was at least some compensation. However, it doesnt have to be that way. Crisis also opens the door to large profits. But you had better don your generals hat and flak jacket. To make this killing you have to charge "into the valley of death" while overreaction is roaring and thundering all around you.

First: Know Your Enemy

A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest. In a crisis or panic, the normal



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