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A Hedged Contrarian Position

Historic Sample:
May 1998, August 1998, November 1998, December 1998, September 1999 November 1999, Summer/Fall 1999, 2000.

What is a hedged contrarian position?

It's funny you should ask.

Since things have been moving along rather fast, here is a synopsis of Lyonvestevents to date:

  1. Feb. 5, 1998 - our first R&D publishing appears on the Internet.
    The recommendation of the publication is to prepare your portfolio for a volatile market place. Specifically, to convert any long term holdings in the stock market to either cash or "contrarian stock and option positions."

  2. Aug. 9, 1998 - a mutual fund is created to take the Lyonvest strategy from a personal holdings R&D project to a group fund using real money.

  3. Aug. 25, 1998 - we make a final plea to the public to put the Lyonvest strategy to work on their personal portfolios.

  4. Aug. 27, 1998 - we hate to say it... but, we told ya so. If you don't have the stomach for a volatile market place, you should have "got out while the gettin' was good."

Now, I have a lot of people asking, "then why were you franticly buying stocks the weeks before the worst 3 days in history?" The reason was to position a certain amount of assets in a "hedged contrarian position." So, now we're back to the beginning question, "what is a hedged contrarian position?"

A hedged contrarian position is a diversified portfolio in which you hedge both a cash position and own a small group of diversified stocks that are "contrary to the market's opinion."

cash

However, 100% cash is not a very diversified portfolio... ask any Russian. Of course, having a mix of the "cash" types listed above will give you some diversity. What would happen if their was a deflationary period? It would be good news/ bad news. The good news -- the longer you hold on to your cash, the less you will need to spend... at least in the short term. The bad news -- interest rates would likely drop, and your rate of return would diminish. As our interest rates fall, investors will look around the world for better interest rates causing the dollar to fall in value.

Deflation leads to Depression leads to Devaluation leads to Inflation.

Let's hope the Chairman of the Federal Reserve Board, Alan Greenspan, can continue his excellent record. It will be a hard road ahead. Lowering interest rates could cause the deflation/inflation cycle to accelerate. Not lowering interest rates could cause a recession.

What is a contrarian stock?

Having some assets in a variety of contrarian stocks and hedging the position by selling call options, might further help divert risk. What is a contrarian stock? A contrarian stock can take on many different forms. An easy example that will work in many types of markets is a stock that has been declining in price. The average investor would say, "I don't want to buy a stock that is falling in value." The contrarian would say, "This stock has already been hammered... perhaps it is even near its 52 week low. Now is a good time to buy it... for it is likely to regain at least some of the old value." There are many other contrarian views, including y2k, terrorist threats, global weather trends, etc.

The Lyonvest portfolio consists entirely of contrarian stocks. At the time of their purchase, the following "contrary" attributes held true:

What can you do with your savings that contains no risk?

What can you do with your savings that contains no risk? Once you think through a few scenarios, you're likely to come to the conclusion that there is nothing you do with your savings that contains no risk. True. But, by implementing the Lyonvest strategy of a hedged contrarian position, you will actually reduce your overall exposure... and drive the risk factor quite near to zero.

How do you hedge a contrarian position?

First, you must have a position.

Well, it is important to remember what a contrarian position is: a point-of-view which is contrary to popular belief. Therefore, the first rule is to obtain your position before public sentiment shifts. Once the volatility begins, smart investment quickly turns into a "crap shoot." By preparing ahead of time, you can first obtain a portfolio consisting of about 95% cash. Then, over a period of 1 to 2 years, you can periodically obtain diversification in your holdings. Finally, prior to the volatility, you should have moved to about 80% cash and 20% in your diversified contrarian stock portfolio.

Remember, we are just talking about your liquid and semi-liquid savings. The Lyonvest Portfolio is a group experiment and that offers but a glimpse of what a personal portfolio should look like. However; it can be used as a model for the "diversified stock portfolio" portion of your overall financial plan.

Remember, an individual should only invest money using this strategy if they plan on being in for the long haul.

This means you must have a savings plan that includes:

  1. saved money
  2. and, a preconceived notion for:
    1. the preservation of value
    2. the potential for capital appreciation
    3. guaranteed income

Then, you hedge the position.

To reduce risk even further, there are several additional sub-strategies that can be implemented. The sub-strategies often include "hedging" your position. An easy way to discover some good ways to hedge your position is to ask "what if?" questions, such as, "what if the Federal Reserve Board lowers interest rates? What if the Federal Reserve Board does nothing with interest rates? What if the Federal Reserve Board raises interest rates?"

By doing enough of these "what if?" scenarios, you will be able to see some "contrary to the contrarian" patterns develop... what happens when you were right with a your original contrary position... and what happens when you were wrong... and what happens if nothing happens. Once you have run though the different scenarios, it will be easier to devise a plan to make money in nearly every case. And at the very least, you will be able to devise a plan not to loose value in your savings. When you make a plan that helps limit your worse case scenerio, it is called hedging.

www.lycos.com historic stock price

The Lycos acquisition is a good example of how a hedge can be accomplished in the real world.

  1. First, start with a good underlying company. When it comes to Internet companies, there are only a few publicly traded companies that "really have something." Yahoo, Spyglass, Netscape and Lycos are a few that come to mind. They have either developed technologies with lasting value or built services on the reality of the world wide web. Lycos invented the spider. They have pursued their ownership rights over this technology.

  2. Next, you should try to time your purchase appropriately in the stock's trading cycle. This could mean purchasing the stock near its 52-week low, or well below its 52-week high, or immediately prior to a spike in the price, etc. Lycos represents the later two. It was purchased at 57% of its 52-week high, as well as, immediately prior to an upward spike in its price. Of course, you must take advantage of the spike by either selling at its peak, or selling a coverd call during the frenzy of the upside, or.... (On the point of "trading cycles," you should determine the amount of time you want to spend monitoring the stock's price. Trading on shorter cycles will require a greater amount of time. Since we wanted to show an example of a complete life-cycle, we choose an Internet stock that has a short trading cycle. But since we don't have that much spare time, we generally like longer trading cycles.)

  3. Finally, you add a twist... or two. The twist can vary. (Some of our stock picks took the dividend yield into account. For instance, ARCO's yield was 4.75% when money market interest rates were the same. This would represent a hedge against falling interest rates. ) The twist with Lycos was to instantly sell a covered call. We received an 18.9% return on our investment the first day.

Ideally, the "call option" would have been exercised by the buyer before we reached the downside of the price spike (see the example graphic above. By the way, another good time to buy is at the bottom of the spike's other side.) Then, we would have received another 5.5% on our money and been back into a cash position... all within two weeks. That would equate to an annual rate-of-return of about 634%. Too bad it isn't a perfect contrarian world.

In any event, we have made money and continue to have the opportunity to make more. And, by combining this individual acquisition into a group of unrelated stocks, the risk factor will approach zero.

Post-mordant

Should you still be able to have a clue of what I'm saying to you, I would suggest that you also diversify further.

In my personal portfolio, I have reduced the overall stock holdings to less than 10% of my net worth. Then, I positioned as many stocks as possible with covered calls... locking in thousands of dollars in profits prior to the market drop. I've also increased the diversity by adding stocks like Coleman (camping/survival gear/generators) and Royal Dutch (a foreign oil company).

I would expect the volatility in the market place to continue into the future. As a matter of fact, I wouldn't be surprised to see the volatility intensify for the next couple of years. If you have not already obtained a hedged contrarian position, my advice would be to hang on real tight. It should be an exciting ride.


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