SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Do all stocks have the same expected returns?


When deciding to build a diversified investment portfolio, there are many different considerations. Which asset classes do you buy? Large cap or small cap? US only, or International too? Mutual funds or ETFs? How much in bonds? Passive or active management? Growth or value?

Without a specific goal in mind and an investment philosophy to guide your decisions, it can quickly become overwhelming. There are two primary asset classes that form the core of an investment portfolio: Stocks and bonds. I find that many investors and advisers intuitively understand and accept the economic logic that longer term bonds have higher expected returns than shorter term bonds, corporate bonds have higher expected returns than government bonds, and stocks have higher expected returns than bonds. This is rational compensation for risk in an efficient market.

If I've already given you brain damage, think about it like this: If a 5 year US Treasury note issued and guaranteed by the federal government was yielding the same return if held to maturity as a 5 year bond issued by a corporation in significant financial distress, which one would you buy? Of course you'd buy the Treasury, as the corporate bond offers no compensation for risk, and a bond is nothing more than a promise to pay you back. 

When the conversation shifts to expected returns on stocks, there is often more debate. Originally, the thought was that differences in returns among stock portfolios could be explained by market beta. In other words, how much equity like risk a diversified stock portfolio or fund has. A portfolio with a market beta of greater than 1 has more equity type risk than the overall market, and vice versa. Therefore stocks with higher betas were thought to have higher expected returns than the market, explained by the greater risk, but applying this model to empirical data showed that market beta only explained about two-thirds of the differences in stock returns.

Eugene Fama and Ken French added to the research in the early 1990's, finding that by adding a stock's size (market cap: small vs. large) and relative price (book value vs. price: value vs. growth) to the equation, more than 90% of the differences in performance among stock portfolios could be explained. The Fama and French model is referred to as the 3 factor model, concluding that there is a difference in expected returns among portfolios that can be explained by their average size, relative price, and market beta characteristics. Smaller stocks with lower relative prices (referred to as value stocks) have unique risks associated with them unrelated to market beta, and this additional risk explains their higher historical returns and implies higher expected returns in the future. 

Image result for small cap value style box

For perspective, since the 1920's, small cap value stocks (measured by the Dimensional small cap value index) have had returns approximately 4% per year higher than the total market (measured as the S&P 500). With the higher risks in mind associated with small cap value stocks, it's rational to believe these higher returns exist as compensation for risk in a similar way that differences in term (time until maturity) and credit (ability to pay) characteristics explain the difference in returns among bonds. The small and value premiums have also been persistent and pervasive across both international and emerging markets, further supporting the Fama/French findings.

Armed with this information, an investor can potentially construct a more efficient portfolio. One that has comparable expected returns as the total market, but with less risk. The 4% higher historical return for small value stocks would have allowed an investor to achieve the same return as the total market with just 40% in small value stocks, and the remaining 60% in the safety and stability of 5 year US treasuries. The net result would have been an almost 40% reduction in portfolio volatility relative to a market portfolio. 

My experience as a financial adviser for more than a decade has taught me that limiting the risk of large losses increases the odds that investors will be able to maintain discipline during bear markets. 

Investors interested in more on this topic can contact me at jblom@lorintine.com. I also recommend the writings and books of Larry Swedroe, especially his most recent book, "reducing the risk of black swans", which is an easy read and can be purchased for under $10 on Amazon.

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • How To Create Your Own Indexed Annuity

    Indexed annuities are a life insurance company product sold by insurance brokers for a commission that is based on the amount deposited into the contract. Contract performance is linked to popular indexes like S&P 500, and early withdrawal penalties typically apply for the first 7-10 years if withdrawals greater than 10% of the contract value are taken each year.

    By Jesse,

    • 0 comments
    • 879 views
  • Q&A with Mental Game Coach Jared Tendler

    QUESTION: Thank you for taking the time to participate in a Q & A session with Steady Option. Let’s start with an introduction and a little bit of background on who you are and how you got here.

    By Jared Tendler,

    • 0 comments
    • 1,103 views
  • Using TLT Options to Increase Expected Returns of a Buy & Hold Portfolio

    TLT is the iShares 20+ Year Treasury Bond ETF that seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. Even though US Treasuries typically act as a diversifying asset class to mainstream equities, many investors with long time horizons may not be interested in holding TLT in their portfolio because it would lower expected returns.

    By Jesse,

    • 0 comments
    • 1,316 views
  • Tax Efficient Trading Part II: Capital Gains Deferral

    In part I I illustrated how the preferential tax treatment of 1256 contracts could improve after tax returns of a PutWrite strategy over a long period of time. In this article, I’ll continue the illustration by switching from a PutWrite to an ETF BuyWrite (covered calls) strategy while holding pre-tax expected returns constant at 8%.

    By Jesse,

    • 0 comments
    • 1,619 views
  • Tax Efficient Trading Part I: The 1256 Contracts

    Cash settled index options like SPX, XSP, RUT and a few others receive special federal tax treatment where 60% of the gains are reported as a Long Term Capital Gain (LTCG) even if the contract was held for less than a year.

    By Jesse,

    • 0 comments
    • 1,604 views
  • SPY Short Puts vs. Put Spreads

    In this article I’ll be using the ORATS Wheel backtesting tool to compare the performance since 2007 of SPY short puts versus short put spreads. I’ll look at both risk and returns, and different ways of determining position size to adjust for the differences in risk between the two trades.

    By Jesse,

    • 1 comment
    • 2,410 views
  • Signs that you Are Ready to Start Investing

    If you want to build your wealth, you have to make sure that you invest your money. If you put money into a savings account and don’t earn any interest from it, this won’t work for you in the long term. Your money will lose value because of inflation, and this is the last thing that you need. So when do you invest?

    By Kim,

    • 0 comments
    • 1,735 views
  • One Year of Diversified leveraged Anchor

    I almost hate to keep saying it, but the Diversified Leveraged Anchor strategy keeps exceeding expectations and performing as designed. To remind our readers, Diversified Leveraged Anchor was created in April 2020 attempting to further increase performance, reduce risk, and to reduce volatility. 

    By cwelsh,

    • 5 comments
    • 2,815 views
  • Should I Pay Off My Mortgage Early Or Invest?

    Paying off a home mortgage early is a popular financial goal. Most people feel a level financial peace when their home is paid off that is beneficial in many ways. The most common approach to paying off the mortgage early is directly making additional principal payments to the lender on a regular basis.

    By Jesse,

    • 0 comments
    • 1,339 views
  • Option Order Execution Tips

    As a community of option traders, we all can relate to the occasional challenges of order execution. Best practices for avoiding errors as well as techniques for better potential execution will be the focus of this article.  Like countless others in the Steady Options community, I personally have traded thousands of option contracts over the last decade.

    By Jesse,

    • 17 comments
    • 2,961 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido