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Constructing an investment strategy

THE Efficient Market Hypothesis, developed by Professor Eugene Fama in the early 1960s, asserts it is impossible to consistently outperform average market returns, because the market is efficient and stock prices reflect all relevant information and trade at fair value.

Those who subscribe to the theory believe it’s pointless to search for undervalued stocks, time the market or predict trends through fundamental or technical analysis.

Dissidents argue there is evidence to dispute the theory. Stocks with low price/earnings ratios, for example, have historically had better returns.

Another example cited is economic bubbles, where buyers may not be operating on the basis of fair value and frantic selling typically follows.

The 1987 US stockmarket crash, when the Dow Jones  index fell 20 per cent in a single day, proved  stock prices can have significant disparity from their fair values.

Given the divergence in phil-osophies, several investment strategies have evolved.

An investment strategy is ideally a plan, with rules and procedures, based on the investor’s objectives, risk tolerance and future capital requirements, that guides the selection of an investment portfolio.

The building blocks of an investment strategy are asset allocation, buy and sell guidelines and risk/return trade-off.

Asset allocation, a form of diversification, is proportioning investments into asset classes to achieve the highest return while minimising risk.

Asset classes are typically cash, bonds, stocks, real estate, precious metals, natural resources and collectibles.

The theory is that different asset classes offer returns that  are not perfectly correlated and will perform differently in different market conditions, reducing the overall risk in the variability of return for a given level of expected return. It’s a key concept in investment management and is considered to be an active management strategy.

An active investment strategy involves building and selecting a portfolio and act-ively managing it to achieve risk-adjusted returns better than a benchmark index.

Active investors believe they can exploit market inefficiencies by buying undervalued stocks or shorting overvalued stocks and time the market, making it is possible to beat the market averages on a consistent basis.

This usually means buying low and selling high (or selling high and buying low, in the case of short selling).

Passive investment, in contrast, involves buying and holding a portfolio that typically tracks a broader index.

This strategy doesn’t entail forecasting, stock selection or market timing, and mini- mises transaction costs. It asserts that it’s impossible to beat the averages consistently on a risk-adjusted basis.

A retail investor would typically buy an index mut-ual fund or exchange-traded fund, whereas an institutional investor would construct a portfolio that replicates the desired index.

It’s been generally proved that indexing outperforms active management in the long  run.

Buy and hold is a passive investment strategy in which a stock is selected, purchased and held for the long term, regardless of periods of volatility or decline.

The assumption is that, in the long term, stocks generally go up and outperform cash and bonds.

Market-timing, on the other hand, involves predicting  price movements, usually on the basis of price and volume data and economic condit-ions. It can involve the use of moving averages.

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