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.

The benefits of diversification


What is the real benefit of diversification? Sometimes it's not completely intuitive to investors. Let me provide an example, using historical data of 2 Vanguard mutual funds, VFINX (S&P 500) and VUSTX (Long term treasuries). For fun, we'll compare the end result to Warren Buffett's performance as well, just to further drive the point.

Since June of 1986, they've both carried Sharpe Ratio's of approximately 0.5. Sharpe Ratio measures excess annualized return / annualized volatility. Excess return is the annualized return of the mutual fund minus the risk free return of T-bills.

 

Portfolio 1 = VFINX

Portfolio 2 = VUSTX

Chart 1.png

 

 

We see that VFINX had a higher return, but also higher volatility. This is what we would expect over a long period of time from relatively efficient markets. And we'd also expect similar Sharpe Ratio's like we see.

 

So what's the benefit of diversification? Well, a risk parity portfolio, where both assets contribute about the same amount of volatility, would mean we need about 40% in VFINX, and 60% VUSTX.

 

Portfolio 1 = 40% VFINX, 60% VUSTX

Chart 2.png

 

 

We immediately see the benefits of diversification where the 40/60 portfolio Sharpe Ratio shoots up to 0.73. That's substantially higher than either mutual fund itself, and even higher than Warren Buffett during this same period where BRK/A produced a Sharpe of 0.64. This means the benefits of diversification are making a portfolio more efficient by offering higher returns per unit of risk. 

 

Are you thinking right now, "yeah, but the return is still less!". That's true, and it's why I often find investors believe that diversification lowers returns. This ignores the ability to use leverage.

 

Let's assume in the following examples that we can borrow at the risk free T-bill rate. This is unrealistic, but the futures market does provide implied financing rates relatively close to this over time. With the ability to use leverage, either by borrowing funds directly through a source of financing such as a bank or a margin loan from a broker (i.e., Interactive Brokers), or indirectly through derivatives like futures and options contracts, we are no longer constrained to investing a maximum of 100%. This means we can use the benefits of diversification to either A. produce similar returns with less risk or B. produce higher returns with similar risk. 

 

A. Similar returns (as 100% VFINX) with less risk by investing 25% more in each fund (50% VFINX, 75% VUSTX). Financed at the T-bill rate.

 

Chart 3.png

 

B. Higher returns (than 100% VFINX) with similar risk (defined as "Stdev", or annualized volatility) by investing 100% more in each fund (80% VFINX, 120% VUSTX). Financed at the T-bill rate. 

 

Chart 4.png

 

These examples are meant to be just that...examples. Leverage creates risks of its own that investors should be aware of, but I personally like the benefits of using moderate amounts of leverage applied to a diversified portfolio to increase expected returns, vs. the more conventional method of simply investing more in stocks. To each his own. I mentioned that we'd compare the results of our leveraged portfolio to that of Warren Buffett's (via BRK/A). So let's take a moment to do just that...interestingly enough, academic research has concluded that a material amount of Buffett's outperformance was due to just that...leverage...1.6X on average. 

 

"Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks."

 

Portfolio 1 =BRK/A

Portfolio 2 =80% VFINX, 120% VUSTX

pic.png

 

Our 2x levered portfolio slightly underperformed BRK/A on an absolute return basis, but slightly outperformed on a risk adjusted return basis due to having approximately 30% less volatility.

 

The risk here for retail investors is when the thought crosses their mind "well, if I can lever up to 200%, why not MORE :Naughty:?" Hopefully I don't have to explain the risks of leverage...just because you can drive a Ferrari 200 mph doesn't mean you should! A rule of thumb is that if you model your portfolio annualized volatility to be more than ~20%, you're probably driving too fast and eventually you're going to crash. For this reason, only highly sophisticated and highly disciplined investors with a strong understanding of modern portfolio theory, statistical probabilities, and quantitative finance should attempt to create portfolios like this on their own. There are many variables to consider, and it's never as obvious as it looks.

 

"You've got to guess at worst cases; no model will tell you that. My rule of thumb is double the worst you have ever seen" - Cliff Asness, AQR

 

"Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there is pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe Ratio of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe Ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade.  You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need." - Cliff Asness
 

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 oversees the LC Diversified forum and 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

Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Long Straddle Options Strategy: The Ultimate Guide

    A long straddle is an options spread that involves the simultaneous purchase of a put and a call at the same strike price and expiration date. It’s a long-options, market-neutral strategy with limited risk and unlimited profit potential.

    By Pat Crawley,

    • 0 comments
    • 225 views
  • Ready to Invest? Here's How to Get Started with Online Trading

    I am struggling with making the decision to get started.  How much money do I need to be efficient and effective following your instructions?  What software and where to find it?  I could really benefit from extra income but I am also in a position where I can't really afford to lose much so there is some doubt/fear.  But, your information and attitude felt right to me so I reached out.

    By Karl Domm,

    • 0 comments
    • 191 views
  • The Importance  of Proactive Hedging in Options Trading

    Investing in the stock market can be a daunting task for even the most experienced investors. With the constant fluctuations and volatility of the market, it can be difficult to predict the future direction of the market. This is where options trading comes into play.

    By Karl Domm,

    • 0 comments
    • 295 views
  • The Silent Bank Run

    Long before Silicon Valley Bank failed, the banking sector was experiencing a silent bank run. Unlike the Great Depression, where lines of people clamoring for their money were blocks long, this silent bank run, as its name portends, has been out of sight until recently. There are a couple of reasons for this. 

    By Michael Lebowitz,

    • 0 comments
    • 225 views
  • High Probability Strategy: A Holy Grail of Options Trading?

    A lot of options traders consider a 90% probability strategy a Holy Grail of trading. After all, if you can win 90% of the time, you should be able to grow your account very quickly, right? Well, not only this is not necessarily true, but in fact, a Winning Ratio alone tells you nothing about your chances to be profitable.

    By Kim,

    • 0 comments
    • 233 views
  • The 10 Best Options Trading Books

    Options trading can be challenging. I look at it as a journey, a long term investment, which is no different that graduating from University. And like University, you need to do a lot of reading, along with a lot of practicing. Fortunately, there are a lot of books out there that can be of tremendous help in this journey.

    By Kim,

    • 0 comments
    • 350 views
  • OptionNET Explorer (ONE) Software

    OptionNET Explorer (ONE) is a complete options trading and analysis software platform that enables the user to backtest complex options trading strategies, analyze their results and monitor them in real-time, all from within a single, user friendly environment. 

    By Kim,

    • 0 comments
    • 336 views
  • Delta Hedging Your Options Strategies

    All traders begin with an introduction to call and put options.  However, it's rare (apart from short puts) that an experienced trader would use these contracts by themselves. Instead, we primarily trade options spreads. There are many benefits to spreads. The variety of spreads are targeted to various market criteria and market environments.

    By Drew Hilleshiem,

    • 0 comments
    • 9,283 views
  • What Happened to SFO Magazine (SFOMag)? Stocks, Options and Futures Magazine

    Remember SFO Magazine? Traders like Jack Schwager and Brett Steenbarger used to write for the publication before its swift shutdown in 2012. What happened. SFO (Stocks, Futures, and Options) magazine was a monthly financial magazine focused on trading and investing in stocks, futures, and options markets.

    By Pat Crawley,

    • 0 comments
    • 1,149 views
  • How to Use the Finest Covered Call Strategy

    Investing in the stock market can be a great way to grow your wealth over time. However, it can also be a volatile and unpredictable place, with sudden swings in stock prices causing anxiety for even the most experienced investors. This is where the covered call strategy comes in - a popular options trading strategy that can help manage portfolio volatility.

    By Kim,

    • 0 comments
    • 857 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