Investment Strategy

Eric Falkenstein has a fantastic blog site here. His viewpoints expressed on the blog are extremely intelligent and commonsensical . Sometimes the topics can be controversial, such as race, income disparity, etc but his thoughts aren’t meant to be offensive, merely looked upon with an objective approach to find some element of truth. I truly admire his writing style and his ability to communicate his opinions about extremely complicated issues clearly. If only I could do the same!

Beyond the fantastic content lies another hidden gem, a link to his personal site. There on his personal site is another link to some of his publications and finally, if one has the patience, is a link to a very simple investment strategy that can beat the pants off the S&P 500 given enough time. The idea is simply to go long low volatility stocks and short high volatility stocks. Common investment theory and the CAPM model state that expected return is a function of risk. No risk, no return? Makes a lot of sense but in finance that is simply not the case in real-life. Falkenstein presents returns from a fund he ran for a few years to demonstrate the power of this simple investment idea:

As you can see, the major out performance comes during market corrections. The annual return is magnitudes above the S&P with the same amount of volatility. So why doesn’t everyone do this?? Well thank god they didn’t otherwise this relative performance would probably fall apart. The real reason as asserted by Falkenstein is that us humans don’t act rationally but act according to comparisons. If our neighbor is making a killing in the market then they will feel envious and look for greater returns. While I was at a hedge fund, a significant portion of our book was simply long S&P futures, sometimes as much as 50% of our book was long futures. Which simply boils down to career risk, if the market was up 30% and we were only up say 15%, redemption. If however the market was down 30% and we were only down 25%, victory.

In another section of that wonderful site is some power point presentations. One presentation on alpha had a portion explaining the difficulty John Bogle of Vanguard funds had in selling a index mutual fund. Nowadays Vanguard is one of the largest mutual funds if not the biggest by AUM due to a very, very simple idea. Buy the benchmark and hold it. This investment strategy has similar potential, all it requires is a little sales & marketing.

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~ by largecaptrader on July 31, 2010.

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