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INTRODUCTION TO BENCHMARK INVESTING
LESSON 1

By: J Vong

Introduction

The objective and use of benchmark investing have been briefly explained in the FAQ. Please read the FAQ to understand the underlying design of the KLSETracker.COM.

Benchmark investing is used by almost all professional fund managers. The proliferation of funds and the competition among fund managers is likely to result in lower returns in the future.

As competition unravels, returns on unit trusts or mutuals may not be as high as previously experienced. This is partly due to the relatively high costs of managing funds charged by some. Such a likely development gives reason for ordinary investors wanting to preserve and to grow his savings to make an effort at understanding the underlying principles and techniques of benchmark investing.

There are several approaches to benchmark investing. Benchmarks can be built based on different theories and principles. Accounting, economic and related statistical studies are the most frequently used.

Mathematical and statistical models using prices and volumes are also popular and referred to as charting or technical analysis. Some exotic fields of studies have tried to establish market benchmarks using astrology.

Calculating benchmarks through the use of economics, accounting and accounting-based statistics as a technique owe their legitimacy to their underlying principles and the fact that they are founded on measurements of real values in business and the economy. Values in business and the economy are generally driven by considerations of use and returns as opposed to stock market values which reflect sentiment, supply and demand.

Charting models are based on stock market prices and volumes. Stock market prices and volumes are driven by short-term market sentiment. These studies are focussed on momentum trajectories and patterns.

Benchmark investing can be approached using combinations of the above theories and disciplines of studies. This can result in a wide range of approaches.

The KLSETracker.COM is designed to provide investors with the more professionally accepted methods of benchmark investing based on statistics and accounting. We plan to provide economic inputs at a later stage. Some technical analysis is used.

Irrespective of the combination or approach is used, the ultimate test of benchmark investing is to determine its level of reliability. It is important to clearly understand the reliability of benchmark investing before learning the use of its techniques.

How Reliable Is A Benchmark ?

The reliability of benchmark-investing is premised on the quality of benchmarks being constructed and used. The key to tracking a market is a proper understanding and the judicious use of selected benchmarks.

Selected benchmarks must be maintained for a reasonable period of time to be useful. They are constructed to reflect historical risks and returns associated with its movements. In statistical terminology, this process is referred to a "back-testing".

Back-testing gives one the ability to establish a long-term statistical averages. Theory has it that the Law of Averages churns out percentages or numbers which are difficult to beat over time. Thus the application of this theory in investing provides the much needed degree of reliability.

For example, let us examine the Kuala Lumpur Stock Exchange blue chip price index - the KLSE Composite Index (KLCI-100). This is a price index built to reflect blue chip companies on the main board. This index was introduced in 1984 when it comprised 80 stocks then. It was increased to 100 stocks in 1990.

Markets change over time and the component stocks are adjusted accordingly. The important lesson that can be learnt from this historical price-index is that it will be difficult to beat the observations resulting from a study of its movements as deemed by the Law of Averages.

An observation that can be discerned from the index is that it fluctuates roughly 40 per cent from its yearly high to low. This observation is valid over a 20- year history given the economic conditions existing over this period of time.

According to a sub-rule on the law of averages, the statistical chance of this annual average volatility being exceeded significantly in any one year is around 33 per cent provided that the underlying economic conditions have changed materially. Such observations, therefore, provide a basis on how to manage long term investments.

By applying the Law of Averages, benchmarks can, therefore, be reliably used for investment decision-making and to statistically compute levels of risk and return.

Types of Benchmarks ?

There are several types of benchmarks. You can have market, accounting, economic, statistical, mathematical even astrological benchmarks and many more. Benchmarks are built with specific objectives. They are meant to highlight various factors and aspects of a market. Commonly used benchmarks are as follows:

1. Price Indices

This index is the most widely used to reflect price movements. Studies of the index will reveal the risks and returns associated with price movements. Many indices are maintained for each market. It is important to know the objectives of each index. It is also important to know the components of each index before using them.

2. Value-Weighted Indices

Value-weighted indices are a little more complex. An example is to compute an index relating a price to an underlying value. So the popularly used PE value or Price to Earnings number relates price to earnings. It shows how price reacts to earnings. This PE value charted over time produces a time series of the number of how prices react to earnings. This resulting time series or index can then be used as a benchmark.

Benchmarks can therefore be constructed to reflect a single factor such as price movements or relational factors such as price to its underlying earnings. Benchmarks used in combination provide effective guides to investment decisions.

Tracking Benchmarks

Tracking benchmarks or "hugging closely" to benchmarks will give you the same characteristics or "ride" of the benchmarker. If the benchmark is reflective of prices, then it becomes possible to quickly compute returns or losses by just noting the index number. Herein lies the reliability in the use of benchmarks.

A key to tracking a benchmark is to know the behavior of each component stock against the standard of measure (the benchmark). Analysts with a statistical background measure the movement of individual component stocks against the benchmark over a long period and come out with an average number which is known as the "beta". Hence, if a stock has a beta of "1.0", its movement will match that of the benchmark.

A simpler technique used in tracking a benchmark is to know the long-term volatility range of every component stock. Hence, if a certain stock were to exhibit the characteristic of fluctuating 40 per cent from it highest price annually, it would make sense for an investor to buy only if the share has fallen by a percentage close to that amount. The individual stock's movement must also be related back to the overall averages or price-index to achieve a more precise action.

The difficult part, however, is the ability to pinpoint the stock's high points and low points. This can be overcome through the use of a statistical averaging method sometimes referred to as "laddering" or a "positions" method. A discussion of this important technique will be done in later lessons.

(Next Lesson will be posted in June, 2000)

(This material can be freely reproduced and distributed. Acknowledgement of copyrights required.)



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