Fotis on August 1, 2013
Hello everyone.Today’s post is somehow special because it comes in two parts.
Firstly we examine a potential opportunity in the EURUSD and keep an eye on the FOMC statement.
In the second part, we discuss something entirely different, we introduce you to some basic concepts of Modern Portfolio Theory.
Let us begin by looking at potential opportunities this week.
Following my previous post, when we were looking at the results of professional fund manager, one fellow member suggested to compare our own results with the performance of currency only funds.
Below you will find the annual results of funds that invest only in currencies.
|
1980
|
-
|
1992
|
10.27%
|
2004
|
2.36%
|
|
1981
|
-
|
1993
|
-3.33%
|
2005
|
-1.21%
|
|
1982
|
-
|
1994
|
-5.96%
|
2006
|
-0.12%
|
|
1983
|
-
|
1995
|
11.49%
|
2007
|
2.59%
|
|
1984
|
-
|
1996
|
6.69%
|
2008
|
3.50%
|
|
1985
|
-
|
1997
|
11.35%
|
2009
|
0.91%
|
|
1986
|
-
|
1998
|
5.71%
|
2010
|
3.45%
|
|
1987
|
29.56%
|
1999
|
3.12%
|
2011
|
2.25%
|
|
1988
|
4.28%
|
2000
|
4.45%
|
2012
|
1.71%
|
|
1989
|
18.89%
|
2001
|
2.71%
|
2013
|
1.74%†
|
|
1990
|
57.74%
|
2002
|
6.29%
|
||
|
1991
|
10.94%
|
2003
|
11.08%
|
My point is not to scare you or to convince you that you cannot do better but, rather to warn you and protect you from false claims and also help you setting up some realistic targets.
Also keep in mind that you have one great advantage and that is your account size. A smaller account gives you more flexibility to get in and out as you please and since you are your own boss, you can trade at any time and choose any different kind of strategy or asset class. Hedge funds cannot do this.
Now, let’s move to the recent events that are happening this week.
This week is extremely important because we have many important data coming out.
Investors are generally having their attention set on the FED and on FED’s intentions to “taper” its QE program. We have explained this extensively, since a couple of weeks ago.
Investors have shifted their attention on the FOMC meeting and a possible confirmation that the FED will begin “tapering” in September. The FED doesn’t like the volatility in the markets and they will try to sound as “neutral” as possible.
If the statement is “dovish”, indicating that the FED will remain accommodative, even as “tapering” begins, then this will be a negative outcome for the US Dollar. On the other hand, a more aggressive statement, an indication that “tapering” will commence without any signs of being accommodative, will most likely help the US Dollar.
Having said that please have a look at the following chart:
As you can see we are inside the trading range we have identified a long time ago. You can see that price has moved straight to our trendline around 1.3290 and has found some resistance there. You can see from the black trendlines that we are inside a big triangle formation. Let us see if the news releases this week will provide a catalyst for a move outside our trading range or if we will head back to the support at the 1.2800’s level.
We will now move to the second part and introduce you to some basic concepts and theory that portfolio managers use.
————————————————————————————————-
This has been a very difficult post for me. How can someone explain the basic principles of Modern Portfolio Theory to a non-financial audience? How can someone explain the essence of Portfolio Theory but, at the same time leave out all the formulas and the mathematical expressions?
Well, what I thought would be more appropriate is to explain all the basic concepts in a simple, as possible, way and also offer some examples, so you can relate the theory with your own experiences.
Let us begin!
The father of the Modern Portfolio Theory is Harry Markowitz, who actually won a Nobel Prize for it. His work on diversification and Modern Portfolio Theory, was used by Sharpe and in 1964 he introduced, to the financial world, one of the most valuable tools, the CAPM.
The Capital Asset Pricing Model (CAPM) in an attempt to predict capital market’s behavior under the condition of risk. This theory showed us how to improve the performance of our investment portfolio and how to effectively allocate our assets. In very simple terms, this theory is about maximizing your return and minimizing your risk. The objective is to select your investments in such a way as to diversify your assets while not reducing your expected return.
As I said I am not going to introduce here the formulas and the mathematics behind it but, rather show you how hedge funds use it.
One of the goals of a fund manager would be to diversify his portfolio because, as we explained the goal is to maximize return while minimizing risk.
If you have all your money in just one stock you are not diversified at all. You need to have a properly balanced and diversified portfolio hence, as the portfolio moves in different ways over time, the winners compensate for the losers. Through diversification the manager reduces the portfolio volatility and also the risk of underperformance over the market.
There are investors that are choosing a passive approach to invest in the market based on the CAPM.
They would say that since markets are efficient and nobody can beat the market in the long run, then all they have to do is to create a portfolio that would have as similar characteristics as possible to the whole market (indexing) and the only thing that they have to manage is their risk. They would allocate their money sensibly between cash, equities, bonds and other assets. The money at risk is obviously limited to what has been invested, so the risk is theoretically limited on the downside. Since they follow the index if the market performs well, the portfolio will do well too. So these types of managers are looking to minimize their risk as possible and gain from the market return.
There are other managers that think completely differently. They believe they have very good trading and stock picking skills and they want to use those skills to extract returns from the market, while at the same time minimizing their exposure. This is totally different than the passive approach we described above. In this case we don’t want to emulate the index but neutralize it.
Let’s say for example you wish to buy the Apple stock, because your analysis indicates it will over perform the market but you think that the overall market is too high. So what do you do?
You allocate a portion of your money to buy the Apple stock and another portion to “short” the market index.
If your skills are indeed that good, you will make a profit whether the market falls or not, provided you have allocated your money correctly.
If the market goes up, you will lose on your short but Apple will go higher even more to compensate.
If the market goes down you will lose on the Apple stock but you will win from your short on the market.
I will not go into more details for now but, if you must remember something is that there are money managers that know they cannot beat the market, so they use a “passive” approach to create a portfolio that “tracks” the market and there are other managers that think they have good skills and they wish to “hedge” their portfolio and extract the “alpha” from the stocks.
Next time we will give you more details and information about the “beta” and the “alpha” and how they are used to control risk and maximizing returns.
Me and Marc are also working hard to provide you with some realistic hands on examples, so please stay tuned!
Have a great week!
Fotis