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.

The Best Chart I’ve Seen in 2020


The best visual aids for learning are often very simple. The chart in this article was created by Paul Merriman, using data from Dimensional Fund Advisors. I primarily use Dimensional Funds in building portfolios for my clients. There are many takeaways from this chart, and I’d like to share a few thoughts that stick out most to me.

But first, a few definitions:

  • “SCB”: Small Cap Blend. This represents an index of US small cap stocks
  • “SCV”: Small Cap Value. This represents an index of US small cap value stocks
  • “LCV”: Large Cap Value. This represents an index of US large cap value stocks
  • “4-Fund Combo”: Equal weight S&P 500, LCV, SCB, and SCV

image.png

 

Academic theory suggests that markets are highly efficient at pricing asset classes so that risk and reward are related. When an asset class has more risk, it should also have a higher expected return. Otherwise why take the risk? Specifically, from lowest risk/reward to highest:

  • 1-month T-bills (cash)…lowest risk, lowest expected return
  • Long term government bonds
  • Large cap stocks (S&P 500)
  • Large cap value stocks
  • Small cap stocks
  • Small cap value stocks…highest risk, highest expected return

We see that the historical data matches the theory over the entire period. But certainly not over every 15-year period, which should be expected…otherwise there wouldn’t be risk if we knew with certainty that holding for 15 years would automatically produce a relative outcome of one asset classes versus another. Therefore, there is no period long enough where we can be certain of any outcome in markets. And for this reason, every investor must consider their own personal ability, willingness, and need to take risk. This is true not only for how much a portfolio should be in stocks vs. bonds, but also how much of that equity allocation should consist of small cap and value stocks. The right portfolio is the one that has the highest probability of meeting your long-term return objectives(one that is well diversified) and is also one that you can stick with.

 

The diversification of the 4-fund combo never gives you the best outcome, which is a price to pay for also avoiding the worst outcome that you’re more likely concerned about. The period of 1960-1974 stands out, a period of 15 years when the popular S&P 500 index underperformed totally riskless 1-month T-bills (along with SCB & LT Gov Bonds). The 4-fund combo, due to the performance of value stocks, still produced a risk premium over T-bills.

Over the long-term, which is the only period an equity investor should care about, diversification can reduce worst case scenarios. Yet it’s interesting that when I review the portfolios of new clients and prospects, it’s extremely rare to find any allocation at all to small cap value stocks. Whether that portfolio was built with the help of an advisor or not hasn’t seemed to matter, indicating that lack of awareness of the historical data is the likely explanation. I’ve written extensively in
other articles about the higher expected returns of small and value stocks, as this has been known for at least 30 years.

 

The last point I’ll make is that the same chart created with shorter periods, such as 1/5/10 year periods, has much more random outcomes. Again, this would be expected, and it’s why increasing your awareness of the range of potential outcomes over various time periods is one of the best things you can do to have proper expectations. My recent articles on market volatility digs deeper into this topic.

 

Conclusion

 

We should all attempt to judge the quality of every decision we make in our lives not solely based upon the after the fact outcome but based on the information we had available at the time of making the decision.  With investments, this is especially true as we can only have historical data and academic theory to guide us. The science of investing is not like other forms of science where laws exist creating certainty of cause and effect outcomes. This means we should focus our attention on the things we can control such as diversification, asset allocation, and rebalancing. Once we’ve built our portfolios according to these principles, we can relax knowing that we’ve maximized our probability of having a successful investment experience.

 

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.

 

Related articles

 

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

  • 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
    • 151 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
    • 121 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
    • 668 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
    • 613 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
    • 1,277 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
    • 784 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
    • 1,745 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
    • 809 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
    • 2,367 views
  • What Trading Can Offer To A Newcomer

    For any first-time investor, one of the most important questions to ask is “why are you doing this?”. Getting into investment can be thrilling and open up new worlds for you, but it can also be draining both physically and emotionally, with long days and sudden market moves always a genuine risk.

    By Kim,

    • 0 comments
    • 999 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