SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

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

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 254 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 649 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 480 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 306 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 1,344 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 5,711 views
  • Call And Put Backspreads Options Strategies

    A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that a stock will move quickly in one direction. Call Backspreads are used for trading up moves; put backspreads for down moves.

    By Chris Young,

    • 0 comments
    • 9,307 views
  • Long Put Option Strategy

    A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is Delta negative, Vega positive and Theta negative strategy. A long put is a single-leg, risk-defined, bearish options strategy. Buying a put option is a levered alternative to selling shares of stock short.

    By Chris Young,

    • 0 comments
    • 10,949 views
  • Long Call Option Strategy

    A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is Delta positive, Vega positive and Theta negative strategy. A long call is a single-leg, risk-defined, bullish options strategy. Buying a call option is a levered alternative to buying shares of stock.

    By Chris Young,

    • 0 comments
    • 11,315 views
  • What Is Delta Hedging?

    Delta hedging is an investing strategy that combines the purchase or sale of an option as well as an offsetting transaction in the underlying asset to reduce the risk of a directional move in the price of the option. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds. 

    By Kim,

    • 0 comments
    • 9,483 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