19-EquityPort Page 571 Friday, March 12, 2004 12:40 PM
Equity Portfolio Management 571the breadth of implementable manager ideas is high. This can happen in a
world where active managers employ an engineered approach to active
portfolio management. However, if the capital market is largely price effi-
cient, then the probability of failing to produce any level of active reward is
high (near one). With market efficiency, investable ideas are transparent,
and their active implications are already fully impounded in security prices.Strategies Based on Technical Analysis
Given the preceding developments, we would be remiss for not shedding
some insight on active strategies based on technical analysis. In this con-
text, various common stock strategies that involve only historical price
movement, trading volume, and other technical indicators have been sug-
gested since the beginning of stock trading. Many of these strategies
involve investigating patterns based on historical trading data (past price
data and trading volume) to forecast the future movement of individual
stocks or the market as a whole. Based on observed patterns, mechanical
trading rules indicating when a stock should be bought, sold, or sold
short are developed. Thus, no consideration is given to any factor other
than the specified technical indicators. This approach to active manage-
ment is called technical analysis. Because some of these strategies involve
the analysis of charts that plot price and/or volume movements, investors
who follow a technical analysis approach are sometimes called chartists.
The overlying principle of these strategies is to detect changes in the sup-
ply of and demand for a stock and capitalize on the expected changes.Simple Filter Rules
The simplest type of technical strategy is to buy and sell on the basis of a
predetermined movement in the price of a stock; the rule is basically if the
stock increases by a certain percentage, the stock is purchased and held
until the price declines by a certain percentage, at which time the stock is
sold. The percentage by which the price must change is called the “filter.”
Each investor pursuing this technical strategy decides his or her own filter.Moving Averages
Some technical analysts make decisions to buy or sell a stock based on the
movement of a stock over an extended period of time (for example, 200
days). An average of the price over the time period is computed, and a
rule is specified that if the price is greater than some percentage of the
average, the stock should be purchased; if the price is less than some per-
centage of the average, the stock should be sold. The simplest way to cal-
culate the average is to calculate a simple moving average. Assuming that
the time period selected by the technical analyst is 200 days, then the