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Conclusion

Many contrarian investors believe that buying stocks that have done badly in the recent past is a good strategy. This strategy is predicated on the belief that investors overreact to new information and push down stock prices too much after bad news (a bad earnings announcement, a cut in dividends) and up too much after good news. The empirical evidence seems to bear out this belief. Studies show that stocks that have gone down the most over a recent period generate high returns if held for long periods. However, these stocks also tend to trade at low prices and transactions costs are high with this strategy. These stocks are also riskier than average.

If you want to succeed with this strategy, you have to begin with a long time horizon and a strong stomach for volatility. You will have to construct your portfolio with care to reduce your exposure to both transaction costs and risk. You will often find yourself losing before you begin winning. Even then, this is not a foolproof or a riskless strategy.


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