Sunday, July 11, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 14

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

This chapter discusses the topic of risk. Currently, the finance industry defines an investment's risk by its price volatility. The theory suggests that investors require compensation for taking on volatility, and therefore securities with higher volatilities have higher returns. Dreman takes issue with this simplistic definition.

First, he points to evidence that suggests volatility and returns are not correlated. This puts a hole in the theory that investors are indeed compensated for taking on more volatility.

Dreman also argues that semi-variance (as opposed to standard deviation) is a better measure of volatility (though still not perfect). After all, nobody would consider a stock that rises more than the market (i.e. that is volatile on the way up) to be risky, so only downside volatility should be considered.

But finally, volatility is only one of the risks investors face. The risks described in the previous chapter, taxes and inflation, should also be considered. The fact that T-Bills (the "risk-free asset" according to the finance industry) have actually lost money over time once inflation and taxes are taken into account suggests volatility does not adequately represent the risks facing investors.

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