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Contrarian investment strategy: the next generation is one of the most investment famous books of all times. This book was written by David Dreman. Currently he is the chairman of the popular consultancy firm in America called Dreman Value Advisors. Dreman is a contrarian investor. This means that he believes in going against market trends or mob ideas (Dreman 45). By going against the popular market forecasts and makes use of investor psychology. In his book Contrarian investment Strategies: The Next Generation Dreman discourages the “red room investment” and encourages the “green room investment.” This paper will give a report of Dreman’s book; Contrarian investment Strategies: The Next Generation.
Dreman’s opinion on predicting the stock exchange
In his book Dreman disagrees with the modern portfolio theorists, fundamental analysis, and Capital Asset model of pricing. The above despite having been instituted to predict the market trend and help business people use their information to make investments have failed terribly. Dreman goes ahead to give historical information showing how the so called professional investors in forecasting the market trend have misled investors leading them to make huge losses. Dreman asserts that it is not easy to make economic forecasts. Many times the forecasts portray opposite results. It is therefore futile to analyze complex information. According to Dreman it is difficult to predict the stock market accurately. He therefore discourages investment in the stock market basing on professional or expert prediction.
Consequently Dreman and his proponents agree that the stock market does not follow the past trends but change in a randomly. Failure to accept this fact has made many experts to be unsuccessful in their prediction (Dreman 72). This lack of success in the prediction in the stock market has also been fueled by the fact that we have dynamic economies with regularly changing social, political, industrial and economic conditions. We cannot therefore depend on the past trend or data.
To prove the forecasting error Dreman gives statistical analysis of data between 1973 and 1996. This data shows that costly stocks disappointed the market by 3.5% per year while low price earnings surprised the market by returning 4.2% per year above the general indexes. It was found out that generally expensive stocks which are favorites underperform at any given moment. The cheap stocks on the other hand which are out of favor over perform at any given moment. Dreman therefore proposes that investors take advantage of predictable error rate by analysts and invest in the stocks that are not favored by the analysts’ data. It is doing this that he goes contrary to the market trend hence the title of his book “contrarian investment strategy”
Contrarian investment strategies
As mentioned earlier these strategies beat the market by making market decisions that are contrary to the crowd. The book analyses American stock exchange. The objectives of contrarian investment strategies according to this book are to enhance high growth and create wealth in the long run. The book proposes buying of as investors who want income cheap stocks which many investors shy away from. This is because the cheap stocks earn greater returns at any given time according to the research carried out between 1973 and 1996 (Dreman 156).
Another strategy is minimization of transaction cost (Greenblatt 78). This is because of the low price to value of contrarian stock. The transaction cost must be minimized because when they build up over a long duration they lower our returns. More so Dreman in his book contrarian investment strategy proposes reinvestment of dividends. This is recommended especially for investors who will take along period in their businesses. This is because contrarian strategy does not believe in speculating the stock market. But this is recommended mostly for those who have steady income. This strategy really looses in the market.
Contrarian strategies within industries
In the industrial sector Dreman still recommends that only the cheapest stocks are to be bought. These stocks are too be bought in different companies this will help an investor to avoid many worries and speculations. This is because growth any of the industries we ascribe to will lead to our gain no matter the period it takes. Similarly a drop in the price will not affect us hence no need of speculation.
Investing during crisis
Another strategy the book proposes is the crisis investment (Brown 88). During crisis for example war times is when the general market shy away from investing. As a contrarian however this is the time for investment. When there is economic crisis, civil, regional or world war investors sell their stock most of the times at a lower price for a contrarian carefully analyze the situation and buy the stock. It will turn out that in a short moment the market will be up again and you will make profits.
According it is possible to avoid some risks. Contrarians define a risk as the probability of loosing capital either due to inflation or through taxes. They therefore believe that two things are key in any contrarian business (Brown 93). First is the ability to preserve capital and secondly the ability to outperform other businesses. Therefore cash offer and bonds is not an option for contrarian. To avoid or minimize these risks contrarian put in place a number of measures. One of the measures is diversification.
Ways of risk minimization
Another strategy that contrarians employ is diversification. Not only does diversification avoid risks but also shun market speculation. This is because not all businesses or stocks crash at the same time. Therefore diversifying spread the risks involved in businesses and especially in the stock exchange. But how exactly do we diversify? They are many ways to diversify. Dreman advocates that investors diversify evenly in the stocks. He proposes that investors diversify in twenty to thirty stocks. In addition the stocks should be uniformly spread in not less than fifteen industries.
Investing in big companies
Investing in big companies is also another way of minimizing risks. Why big and not small companies. To contrarian investment strategy, it is dangerous to invest or work with small companies because of the question of their sustainability in the market. The advantage of working with big companies is that they are more reliable and their sustainability in the market is predictable. In addition, big companies are in the limelight as a result undergoing more scrutiny compared to the small companies. The scrutiny puts checks and balances to the company. Of advantage also is their popularity which attracts many customers than their counter parts.
However in the event that there is no opportunity or ability to invest in big companies there are opportunities to operate small contrarian ventures. But certain facts have to be put into consideration. First and foremost the small companies must have stable financial base. For manufacturing firms they should not have a debt in capital of less than sixty percent. These companies must have increasing, thoroughly protected dividends and the dividends should be above market yields.
The companies should also have their earning rates above the average growth rate earnings. Investors are however cautioned to diversify their stocks in these companies probably twice as much as those investing in the big companies. Lastly the investors in the small companies should endeavor to be patient owing to the fact that returns may not take a very short period. The book also recommends investment in businesses with earnings more S&P 500 because they are less likely to crash down soon. When stocks seem to deteriorate they should be sold to avoid further losses.
Contrarian investment strategy is one of the best investment opportunities that investors should seize instead of relying on speculation in the stock exchange which is less predictable and carry enormous risks.