Going for volatility – or for patience
Two investment approaches are pitted against each other: one is based on a discretionary style requiring market opinion, and the second is more systematic
Buying a basket of good stocks and selling short the same amount of bad stocks is not as straightforward as it may first appear, but this kind of operation does have one big advantage: the portfolio tends to be market neutral, as the specific market risk is eliminated by the individual long and short stocks.
A big downward or upward movement of the index should therefore leave the value of the portfolio unchanged. However, being completely market neutral is not really the objective of an investor or a speculator, the ultimate goal is in fact to make a profit.
Positive trend
In a positive market, you would like to own those stocks that perform better than the index, whilst being short in those stocks that are unable to follow the positive trend of the market.
In a negative market, you would like to be short in those stocks that perform worse than the index whilst owning those stocks that show a positive performance.
This sounds obvious, however it may be worth considering other solutions. The first, discretionary approach requires a market opinion. You own high beta stocks and short low beta ones in a positive market environment or vice versa.
Less favoured approach
Beta measures the volatility of a stock in relation to the equity index.
This is the less favoured approach, as it is basically dependent on the market direction.
The second option is a systematic approach compared to the previous discretionary one.
The basic idea of the second approach is as follows: own high capitalisation stocks that are inexpensive and that tend to perform better than the market averages.
Next, short those high capitalisation stocks that are expensive and that tend to perform worse than the market averages. Selling short means that the shares are borrowed and sold in order to buy them back at a lower price in the future and thereby cover the short borrowing of the securities.
Important element
Experience has shown that the valuation alone does not make a good long/short portfolio. This is one of the reasons why performance is an important element for the selection of the two portfolios. The selected stocks should be held for a period of six to 12 months.
This strategy will work out well with the exception of one market event, namely a roaring bull market in the growth segment, as the short portfolio is heavily exposed to the technology sector.
Remember to consult future issues of PWM, as the results of this strategy will be reviewed.
For further information on Brainpower’s professional portfolio analysis software, please visit www.brainpowerweb.com or contact Andrew Deakin on +44 (0) 20 7337 9123
