TRADING SYSTEMS

Leverage Or Not, Here We Come
Risk-Adjusted Return

by MH Pee

Comparing two different trading strategies can be a challenge. Here's a technique that does it.

How do you compare stock trading without using leverage and trading something like futures, which does involve leverage? You could do two things. First, you can make both portfolios assume the same amount of risk by adjusting the account size for each portfolio. The larger the account size, the smaller is the risk. If both portfolios have the same risk, then the one with the larger return is better. Second, you can vary the account size for each portfolio until both have the same return. A larger account size results in a smaller return. In that case, the one that assumes a smaller risk is superior. In this article, I use the first method -- using the risk-adjusted return to make comparisons between different portfolios.

THE GOOD OLD DOW

The Dow Jones Industrial Average (DJIA) may be the best-known index in the world. It consists of 30 of the US's bluest-chip companies, including Coca-Cola and General Electric, just to name two. They are among the best-known, most widely followed and owned companies. Since January 1980, the DJIA has moved from a value of about 800 points to its current value of more than 10,000 points. Had you invested in the 30 companies in the DJIA in 1980, every dollar that you put in would currently be worth about $12.50. That represents an average annual rate of return of approximately 11.46%.

About 80% of the mutual funds fail to outperform the DJIA over the long term. Hence, it is quite reasonable to compare various strategies with this benchmark, one that 80% of the brightest fund managers fail to keep up with. Any strategies whose risk-adjusted return is below that of the DJIA may not be worth the time and effort, as we could replicate the performance of DJIA by investing in various index funds, which is hassle-free when compared to following a strategy by yourself.
 

...Continued in the September issue of Technical Analysis of STOCKS & COMMODITIES


Excerpted from an article originally published in the September 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2006, Technical Analysis, Inc.

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