The Contrarian

David Dreman, Forbes Global, 04.02.01


The chances you take

         If you have owned blue-chip technical stocks for the past year, you have already lost 60% to 70% of your money. But it's not too late for you to take a good hard look at risk. In the late bull market the definition of risk seemed easy. It was the danger of not keeping the bulk of your capital in hot stocks that could triple in the course of a year. But today there are an awful lot of investors who define risk as owning any such stock. Both are herd perceptions, and both lead to disaster.

Among academics and consultants there's yet another formula, called beta‹and it's as bad as the two I just mentioned. Beta is a statistical measure of so-called systematic, or market-related, risk. (It is not, as popularly believed, strictly a measure of volatility. Note that Newmont Mining is plenty volatile and yet has one of the lowest betas in the Value Line universe.)

I don't disagree with the arithmetic behind beta, but I do disagree strongly with what the statistic is supposed to mean. The theory is that high-beta stocks are riskier than low-beta ones but reward you with better returns over the long run.

Well, they don't deliver those rewards. Even Eugene Fama, one of the early apostles of the efficient-market theory that's built around such statistics as beta, renounced his faith in the measure. In a paper he wrote in 1992 with Kenneth French, his colleague at the University of Chicago, Fama found that no correlation existed between risk and return. In Fama's words, "Beta is dead."

What else is there? Well, there's a more direct measure of volatility‹namely, standard deviation of daily (or weekly or monthly) returns. The standard deviation will tell you whether a stock jumps around a lot, but it scarcely gets at the more fundamental matters of risk. Is there a risk that the industry you are investing in will not even exist in ten years? Is there a risk that you are caught up in a speculative bubble and are paying ten times what the stock is worth? Neither beta nor volatility comes close to capturing such risks.

If you want to assess risk, think about the big picture. Think about things like these:

€ A company's financial strength. Does it have a strong ability to sail through tough times? If I buy a group of pharmaceutical or tech stocks with enormous financial muscle, I have a very small chance of losing my investment as a result of financial problems. Pay a lot of attention to balance sheets.

€ The price of the stock in relation to its fundamentals. There is always the risk of paying too much for even the soundest businesses. Buy stocks at or below market multiples‹of price to earnings, to book value or to cash flow (in the sense of net income plus depreciation). Some value managers like these ratios to be in the lowest 20% of all stocks. Following this precept would have kept you clear of the tech wreck.

€ Inflation. Jeremy Siegel, in his book Stocks for the Long Run, showed that U.S. stocks significantly outperformed U.S. Treasury obligations over the past 190 years. Taking Siegel's work a step further in Contrarian Investment Strategy: The Next Generation, I showed that the gains of stocks over Treasury bills increased enormously in the post‹World War II period.

Why? Because inflation, minimal before the war, rose sharply over the next 50 years. An investor who held Treasury bills, the supposedly "riskless investment," between 1946 and century's end would have had a real pretax return of only 0.4% annually. Stocks, on the other hand, would have returned 8%. (Long-term Treasury bonds, by the way, scarcely did a better job than Treasury bills in keeping up with inflation.)

Compounded over a working lifetime of 40 years, the spread between an 8% return and a 0.4% return is enormous‹almost 19-to-1 in the purchasing power you have at the end of the period. Now think about this risk: the risk of earning too little and having to retire in penury. For young savers that's a much more consequential risk than the risk of losing money in a stock in the next year.


A year ago millions of investors had persuaded themselves that there was no risk of overpaying for a Cisco or a Yahoo because tech stocks always bounced back. Today the same people have persuaded themselves that all equities are too risky. Both views are very wrong.

David Dreman is chairman of Dreman Value Management in Jersey City, New Jersey. His latest book is Contrarian Investment Strategies: The Next Generation. Find past columns at      All Rights Reserved       Terms,