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.

Realistic Expectations: Using History as A Guide


One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.

For example, Bernie Madoff was able to run the largest Ponzi Scheme for decades by intimately understanding human psychology.
 

Criminals like Madoff are often highly intelligent people who know how to prey on human emotion. He knew that if he told people they were making extraordinary returns they’d get suspicious and he might get exposed for the fraud that it was. So he instead played on the emotions of investors, many of whom were savvy enough that they should have known better, by telling customers they were making above average returns without the commensurately higher risk. During the 2008 Financial Crisis, investors were so panicked that they were selling investments of all kinds, causing Bernie’s house of cards to finally collapse.
 

So how can we use history as a guide? We first should consider the words of Spanish philosopher George Santayana – “Those who cannot remember the past are condemned to repeat it.” A basic tenant of investing is that the path to higher returns is found through taking higher risks. Anomalies that suggest higher returns without a commensurate increase in risk should be approached with a high degree of caution and skepticism. 

It’s also important to note that academic theory and evidence tells us that not all risks come with higher expected returns…such as selecting individual stocks. We should only take compensated risks in the form of diversified portfolios and avoid taking uncompensated risks like holding individual securities.

Below are several widely known risk factors that leading academic researchers have identified to lead to commensurately higher returns:

  1. Diversified bond portfolios have higher expected returns than riskless Treasury Bills.
  2. Diversified total stock market portfolios (Market Beta) have higher expected returns than bond portfolios.
  3. Stock portfolios with increased weightings toward smaller (Size) and lower priced(Value) companies have higher expected returns than market portfolios.

With this information in mind, investors can construct well diversified portfolios based on their own unique ability (time horizon), willingness (risk tolerance), and need (required return to reach goals) to take risk. But the nature of risk and return is that expected returns do not always result in realized returns. If the relationships described above always played out as expected, there would be no risk. So back to the concept of history as a guide, we can look back to see how often these relationships between risk and return did not work out.

 

image.png


The above chart is from Larry Swedroe’s excellent article, “Value Premium RIP? Don’t You Believe It”. The chart tells us how frequently each source of expected return was not realized over 1/3/5/10 and 15 year rolling periods since 1927. For example, the US stock market underperformed riskless Treasury Bills over 30% of 1 year, 19% of 3 year, 16% of 5 year, 7% of 10 year, and 0% of 15-year periods since 1927. Investors simply aware of this data would be much better equipped to make sensible investment decisions as well as understanding proper expectations.


If you had capital you could invest for 1 year, you likely wouldn’t take risk if you knew there was a 30% chance of failure. Additionally, the magnitude of failure over one year can be quite great, with the stock market not only underperforming risk-free treasury bills but also producing losses (occasionally large ones). Now contrast this with the 15-year timeframe where there has never been a period of underperformance, making the thought of holding riskless treasury bills for this long (or longer) seem equally as irrational as holding stocks for only one year. Forewarned is forearmed.
 

As it relates to the actual equity portfolio, many investors are surprised by the historical evidence that increasing exposure to small and value stocks has outperformed a market portfolio about as often as a market portfolio outperforms treasury bills. My firm recommends the use of Dimensional Funds for the implementation of this research, and since 1970 the globally diversified and small value tilted Dimensional Equity Balanced Strategy has outperformed a market like S&P 500 portfolio in 80% of 10-year periods by an average of more than 3% per year.  Note this also would have occurred with comparable risk due to the benefits of diversification.

 

image.png

 

Conclusion

 

It’s very easy and human to overcomplicate things, including investment decisions.  The knowledge and historical perspective of a great financial advisor with a focus on the best interests of the client can lead to better investment experiences and greater peace of mind. A focus on the things that we can control, such as allocating capital according to time horizon, diversification, fees and expenses, taxes, and rebalancing are all ways we can stack the odds in our favor. Understanding the historical probabilities can also lead to greater patience to endure the difficult times when the known risksof investing actually show up. Enjoy the ride!

 

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™ professional. 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 manages the Steady Momentum service, and regularly incorporates options into client portfolios.

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

  • Probability and Option Risk

    A lot is said about probability of profitable outcomes in option trades, but do we truly understand what probability is or how it works? Options traders can become better informed and even wiser by looking a step beyond the well-known conclusions.

    By Michael C. Thomsett,

    • 0 comments
    • 302 views
  • Using ORATS in Anchor Testing

    The purpose of the below piece is to demonstrate how Lorntine Capital uses ORATS (Options Research and Technology Services) in our own backtesting. Note: ORATS does not pay me for writing this but has requested that if we like the software, we assist in promoting it.

    By cwelsh,

    • 1 comment
    • 375 views
  • Calculating the Probability of Option Payoff

    A calculation of “breakeven” as well as maximum profit or loss, sets up a single system for modeling and comparing one option to another. But it might also require traders to adopt an unrealistic assumption about outcomes based on best-case or worst-care scenario.

    By Michael C. Thomsett,

    • 0 comments
    • 417 views
  • Realistic Expectations: Using History as A Guide

    One of the biggest challenges I come across with the typical investor is maintaining realistic expectations and being able to properly understand the tradeoffs between risk and return. We all want high returns with low risk and there’s no limit to the efforts we’ll make to find it.

    By Jesse,

    • 0 comments
    • 435 views
  • CAPM As an Alternative Option Pricing Model

    Options traders endlessly debate the merits of the Black-Scholes pricing model. Some swear by it and others don’t even try to use it. Given the many profound flaws in the model, it is not an accurate tool for developing a sense of where price is likely to move in the future. But there are alternatives.

    By Michael C. Thomsett,

    • 0 comments
    • 601 views
  • Option Payoff Probability

    Options traders must, naturally, be concerned with the likelihood of payoff for a strategy. Ironically, one of the most often cited statistics about profit and loss is simply incorrect. That statistic is captured in the headline of a story posted online “Trading Options: Data Shows That 75% or More of Options Expire Worthless.”

    By Michael C. Thomsett,

    • 0 comments
    • 697 views
  • The Minimum Effective Dose (MED) For Cash Flow Planning

    Financial planners can usually give generic advice that will be appropriate for the majority of Americans, and that’s the goal of this article. If we can get the fundamentals of cash-flow planning right (where to put your money after you earn it and pay your taxes and bills), we’re 80% of the way towards maximizing our financial situation.

    By Jesse,

    • 0 comments
    • 693 views
  • Are You Breaking Even? Or Losing?

    Among the good reasons to trade options is the need to meet or surpass your breakeven yield. This is the yield you need just to preserve your purchasing power; and it higher than most people think. In fact, most people relying on moderate to conservative yields from stocks, mutual funds, real estate and savings accounts might be earning well below this breakeven level.

    By Michael C. Thomsett,

    • 0 comments
    • 794 views
  • Buy When You Have the Money, Sell When You Need the Money

    Money can be quite an emotional topic for many of us. Emotions can enhance our experiences and relationships in many ways, but they can act as mental roadblocks especially when trying to make wise financial decisions. One of the most common emotional roadblocks I come across when working with individuals is an unwillingness to invest idle cash to meet long-term goals.

    By Jesse,

    • 0 comments
    • 1,605 views
  • Strategy Selection vs. Risk Management

    "A billion here, a billion there, and pretty soon you're talking about real money." Everett McKinley Dirksen. Let’s begin with the bottom line: When I talk to anyone about the concept of choosing an option strategy (or two) to adopt for trading, I stress that the strategy should have certain characteristics.

    By Mark Wolfinger,

    • 0 comments
    • 763 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