In my new investing book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies, I outlined the investment approaches of ten highly successful long-term investors. One of the individuals I highlight is the well-known contrarian, David Dreman. Dreman is chairman of Dreman Value Management and a longtime Forbes magazine investment columnist. I hope you enjoy the following excerpt from Chapter 5 of The Guru Investor, which discusses who David Dreman is, what his strategy consists of, and how to best implement it. I will be publishing a follow up to this piece in which I will highlight 20 stocks that meet an all-important variable in Dreman’s investment approach.

David Dreman — The Great Contrarian

Dreman, whose company now manages more than $20 billion in assets [at the time the book was written], embraces his contrarian reputation. He uses the word “contrarian” in the title of several of his books on investing, and the jacket of Contrarian Investment Strategies refers to his yacht, named The Contrarian. While there may well be a naturally rebellious side to him, there are also some very concrete, intelligent, and observant reasons that Dreman adopted his swim-against-the-tide approach.

More so than perhaps any other guru we’ll examine, Dreman is a student of investor psychology. In fact, his first book, written in 1977, was titled Psychology and the Stock Market (unless otherwise noted, however, all quoted material for this chapter comes from Contrarian Investment Strategies, which also deals heavily with investor psychology). This makes Dreman particularly worth reading because he presented not only an implementable, proven strategy for investing; he also addressed the psychological reasons that many investors fail. Being aware of these dangers is useful, whether you are using Dreman’s strategy or a different one.

In Contrarian Investment Strategies, Dreman essentially states that he believes there are relatively simple, proven strategies you can use to beat the market—particularly contrarian approaches—yet most investors “cannot follow through” and stick to these strategies. Why can’t they?

According to Dreman, investors cannot follow simple strategies to beat the market because they are prone to overreaction, and, under certain well-defined circumstances, overreact predictably and systematically. For instance, if a stock is considered “good”—it’s one of the “hot” stocks you read about in the paper, hear about on cable TV, or get tips about from your friends and coworkers—investors consistently overprice it. If a stock is “bad”—its price has been dropping, the company is making negative headlines, there are concerns about its industry’s future—investors underprice it. What’s more, this overvaluing of the supposed “best” stocks and undervaluing of the supposed “worst” often goes to extremes.

Dreman thus found that the market is driven by how investors react (or, perhaps more to the point, overreact) to “surprises.” These frequent surprises include earnings reports that exceed or fall short of expectations, government actions that might affect a stock, or news about new products. What’s more, he believed that these surprises were often precipitated by analysts—mainly Wall Street analysts—who were more often than not wrong about their earnings forecasts. He writes:

There is only a 1 in 130 chance that the analysts’ consensus forecast will be within 5 percent for any four consecutive quarters. …To put this in perspective, your odds are ten times greater of being the big winner of the New York State Lottery than of pinpointing earnings five years ahead.” (Dreman’s emphasis)

When you put investors’ tendency to overreact together with the frequent surprises in the market, you get to the crux of why Dreman believed so much in a contrarian approach. Surprises occur a lot, he believed, and because the “best” stocks are often overvalued, good surprises can’t increase their values that much more. Bad surprises, however, can have a very negative impact on them. On the other hand, because they already tend to be undervalued, the “worst” stocks don’t have much further down to go when bad surprises occur. When good surprises occur, however, they have a lot of room to grow. And, Dreman found, the effect of an earnings surprise continues for an extended period of time.

His conclusion: Buy out-of-favor stocks because surprises (positive and negative ones) are commonplace. If you own favorites, you’ll get clobbered by negative surprises but won’t get much upside by positive surprises; whereas if you own out-of-favor stocks, you’ll hardly be penalized for negative surprises but will be rewarded handsomely by positive ones.

This sounds logical, but Dreman found that even people who had an idea of this concept often didn’t follow it. Part of the explanation for that, he found, was that people tend to be overly optimistic. They have unrealistic optimism about future events, thinking such events will come out better than they realistically are likely to be. In other words, they view themselves in an unrealistically positive light and they have unrealistic confidence in their ability to control a situation.

For example, they may believe that having lots of information will shield them from surprises in the market because they have studied everything worth studying and therefore know all that’s worth knowing. An example Dreman gives regarding how this overoptimism can play out is the securities analyst who knows that high-flying stocks will drop from the skies faster than a pelican diving for a fish if earnings come in below the Street’s expectations. Yet the same analyst will still recommend high flyers because he is confident he knows enough about the stocks he has recommended so there is no chance they will experience negative surprises. That might happen to other analysts, he thinks, but not to him. Of course, given the unpredictability of the market and events surrounding it, there’s a good chance it will happen to him.

The bottom line for Dreman is that investors should never underestimate the probability of a negative surprise occurring, because they occur quite often, and can send an overvalued stock tumbling.

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The preceding was excerpted from John Reese’s new book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies.