Book Reviews

Book Review: Psychology and the Stock Market by David N. Dreman

I like reading old books about the stock market.

Hardcover.

I hunt for them on ebay like Indiana Jones.  And luckily I don’t have to dodge arrows or huge concrete rolling balls of death to get them!

One of the best books I found this way is Psychology and the Stock Market written in 1977 by David N. Dreman — a serious contrarian trader who still runs a fund today.

In a nutshell, this book has blow my mind wide open regarding the role of the institutional investor, the fund manager and the so-called “smart money”.

Smart Money Vs. Dumb Money

You hear a lot of talk in the market about “smart money” vs. “dumb money”.

The “smart money” is supposed to be the plugged in, educated, heavily funded institutional investor or fund manager who buys at the right time, sells at the right time and does so in a calm, rational, unemotional fashion.

The dumb money, on the other hand, is the small time retail trader like you and I.  The investing public if you will.  The little guy who buys at the top, sells at the bottom, loads up on individual positions and trades emotionally based on tips, news, gut feelings, guesses, astrology and whatever else.

These poor souls NEVER win in the market and they are continually filling the smart money’s pockets.

Or so we’re told.

Enter the Institutional Dumb Money

I know, I know — it sounds weird just to say it.  How can institutional traders and fund managers — with all of their access to information, tools, analysts, order flow and MONEY be even remotely connected to DUMB MONEY? In a word: accountability.  In another word: conformity.

On page 108 Dreman explains:

One of the most insidious outcomes of the need to perform is the investment manager’s attempt to avoid any action displeasing to the client.

Did you get that?  Any action displeasing to the client.  The client. The fund manager might be a pro, he might know what he is doing, but if the client doesn’t get the concept or isn’t happy or might not be happy, the fund manager won’t take action.

When I read something like that I see that the public — the non investing public — is still controlling the movement of money to a large extent. This control happens on a quarterly basis when clients vote with their dollars.

If a fund manager hasn’t been in the big winning stock that quarter ther is a strong psychological push to buy into the stock, no matter how far over extended price might be.  Worse yet, if the manager has a real dog on the books, the natural instinct is to get out of the position, no matter where that might be.

So you see — while the public might not actually be trading the manager’s money — in a sense they are.

So instead of the dumb money being a harmless little guppy — it’s suddenly become (for me) a big dumb whale — that IS capable of moving the market and creating trends.

So How Does this Info help?

Well, for one, it helps give me a clearer picture of what’s going on in the land of big money funds. Second, it lets me know that there are a lot of mispricings out there in market land as greed and fear really do still rule the market and that it does pay to go against the grain and it most certainly pays to be a small, quick fish beholden to no one, swimming in a sea filled with big, dumb whales.

See, Dreman is contrarian trader.  he goes against public opinion.  Which means when everyone else is selling he is buying and vise versa.

Want an example?  Take a look at Sears ($SHLD) recently…

Sears Stock Chart

At the bottom of a long torturous downtrend for Sears we see a high volume crash, followed by a 181% GAIN.  Does that make sense to you?  It does if you look at it from the perspective of fund managers not wanting to close out the year with a dog like SHLD on their books due to potential pressure from clients.

How Can I Form A Strategy Around This Info?

Dreman is a contrarian investor through and through — meaning he looks for good stocks beaten down and out of favor with the market.

I trade a lot of low priced stocks so that automatically puts me in the pool of out-of-favor stocks.  I do this because I too have done many studies on the advantages of looking for stocks trading at their lows.  It is a viable strategy.

In addition to this I also follow big brand name stocks — and pay close attention to those selling at lows.  And if I see a bargain, I’ll take a position.  More times than not these trades work out well and later this year I’ll be creating a watchlist to show you just how well.

Read the Book

If you want to check a copy of this book out you don’t have to go hunting all over ebay like I did — you can pick up a copy of Psychology and the Stock Market by David Dreman over at Amazon.  I’ll admit, it’s a little dry, and the stock examples are from markets past — but the insights are just as valuable today as they were when Dreman was discussing them.

3 Comments

  1. Daniel December 19, 2016
  2. Sarah Ballard March 22, 2017
  3. Kerry Beck April 23, 2018

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