Benchmarking and Leverage - Prashanth K

A friend of mine was recently suggesting to a group, where I was part of, that the easiest way to pick stocks was to get MetaStock, run its indicators and select a list of stocks based on discretion.

I generally argue against such BS, but did not have the mood to do so and let it pass. But the information he sought to convey is that all you needed is MS and a data provider and well, you could well be on the way to riches and glory.

Just yesterday I was discussing with a friend (who is also a client of mine) about the importance of 'Benchmarking'. I believe if a system is not able to generate at the minimum twice the return of a said benchmark (after deducting all expenses incurred in regard to trading that system), it may be wiser to be a Buy and Hold (or shall I say Buy and Hope) investor - since one can spend the same time doing some other profitable work.

Generally when computing returns, people forget the risk they take (leverage) and instead calculate directly the net profit or loss. A friend of mine recently showed me a list showing the returns generated by him for his clients. He has over nine months averaged around 5 percent per month, net of brokerage and taxes.

While on the face of it, it's a commendable performance, what one misses is the fact that he uses nearly 5 times leverage to achieve such returns. The question that one should then ask is whether the risk is worth the reward. Five times the capital is no small leverage and one bad move can wipe out returns generated over months together. Hence once should carefully evaluate risk rewards before entering any kind of trade.

The author is a member of Bangalore Stock Exchange.