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? 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.

If I've already given you brain damage, think about it like this: If a 1 month treasury bill issued and guaranteed by the federal government was yielding the same return if held to maturity as a 30 year bond issued by a corporation in significant financial distress, which one would you buy? Of course you'd buy the 1 month T-bill, as the 30 year 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 stocks could be explained by market beta. In other words, how much equity like risk a stock or fund has. A stock or fund 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 total market, 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 stocks 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 stocks that can be explained by their size, relative price, and market beta. 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 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 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. 

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.

Edited by Jesse

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

  • 7 Ways To Avoid Forex Scams

    Forex scams are becoming frequent. Michael Greenberg reports on luxurious expenses, including a submarine bought from the money taken from forex traders. The forex industry is recently seeing more and more scams. Here are 7 ways to avoid losing your money in such scams:

    By Kim,

    • 0 comments
    • 135 views
  • Historical Performance of Selling S&P 500 OTM Calls

    If you’re comfortable owning an S&P 500 index fund, you should also be comfortable with covered calls. For example, CBOE publishes data on a simple covered call strategy with their BXMD index. The description from CBOE is as follows:

    By Jesse,

    • 0 comments
    • 141 views
  • Are Trusts the Best Way to Leave Money to Your Heirs?

    First, this is a general comment. Every person’s situation is different. I could say “95% of people don’t need this,” and you could be in the 5% who do. So, don’t ever make personal investment or estate planning decisions based on an online post, contact an actual investment advisor or attorney - most will have initial conversations for free (I do).

    By cwelsh,

    • 0 comments
    • 122 views
  • Anchor and Steady Momentum update

    As our members know, we introduced a new strategy to our members few months ago - Steady Momentum. The goal is to produce higher risk-adjusted returns than the underlying indexes. We also introduced a new version of our Anchor Trades strategy. This post will provide an update on both strategies. 

    By Kim,

    • 0 comments
    • 192 views
  • GBP/USD: If Boris Johnson Becomes PM, Volatility will Rise

    UK PM May is set to step down and Boris Johnson is the leading candidate to replace her. The erratic former foreign secretary may increase GBP/USD volatility. Despite Johnson's Brexit credentials, he could surprise and be pound-positive.

    By Kim,

    • 0 comments
    • 259 views
  • How Steady Momentum Captures Multiple Risk Premiums

    Our Steady Momentum PutWrite strategy attempts to outperform the CBOE PUT index, which writes cash secured puts on the S&P 500. An investable version of this strategy can be purchased with the ETF PUTW. The historical data for PUT extends back more than 30 years, highlighting how writing puts can be an attractive strategy.

    By Jesse,

    • 0 comments
    • 202 views
  • What Options Traders Need to Know About Dividends

    Higher dividends are better, right? Yes, usually. But not always. Dividends are a fundamental indicator and many options traders are not interested in fundamentals. But as a means for picking stocks on which to trade options, some fundamentals offer great insight.

    By Michael C. Thomsett,

    • 0 comments
    • 300 views
  • BTC/USD Struggles To Maintain Newly Conquered Territory

    The first condition to declare the market is in bullish mode has been fulfilled. Now it is Ethereum's turn to assume its part of the game. XRP/USD keeps a low profile, waiting for its chance. We begin the week of analysis celebrating the bullish behavior of Bitcoin late on Sunday.

    By Kim,

    • 0 comments
    • 285 views
  • Fear of Options Assignment

    One of the most common fears in option trading is one of early assignment.  The fear of having a large number of shares (or a large short position) coupled with a potential margin call (or Reg-T call) causing a sudden shortage of cash in their accounts worries investors.  Investors commonly view assignment as a huge potential risk.

    By cwelsh,

    • 1 comment
    • 431 views
  • The Value of Equity Asset Class Diversification

    This investing lesson is a tale of two time periods that highlight the important role of equity asset class diversification and systematic rebalancing in an equity fund portfolio.  Human nature is a failed investor, when our natural instinct is often to do the exact opposite of what we should do in practice.

    By Jesse,

    • 0 comments
    • 352 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