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 where 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

  • Cyclical versus Historical Volatility

    The interest in volatility for options trading is logical and understandable. However, the nature of volatility in not universally understood or agreed upon. In fact, it is more complex than most people believe. Options traders think of volatility coming in two forms, historical and implied.

    By Michael C. Thomsett,

    • 0 comments
    • 120 views
  • Pros and Cons of Paper Trading

    My first recommendation to all new SteadyOptions members is to start with paper trading, then start small and increase your allocation as you gain more experience and confidence. Over the years, we had a lot of discussions related to the benefits of paper trading, and this article will discuss some of the pros and cons.

    By Kim,

    • 0 comments
    • 166 views
  • Does “Managing Winners” Add Value to Short Strangles?

    Some option educators suggest short strangles have historically benefited from actively managed exit strategies. A widely popularized approach is to enter S&P 500 strangles at 45 DTE and exit at 50% of the credit received or a 21 DTE time stop, whichever occurs first.

    By Jesse,

    • 2 comments
    • 333 views
  • Fat Tails and Option Returns

    When it comes to calculating likely returns from option activity, traders contend with a variety of variations. Returns may be skewed (with declines in value more likely than increases), or unstable in many forms. Or the outcome might reveal itself in the form of a fat tail.

    By Michael C. Thomsett,

    • 0 comments
    • 227 views
  • What To Do In A low Yield Environment

    Investors over the world are struggling with yield in their portfolios.  Government investments are at historically low levels, with thirty-year treasuries basically declining every year for almost thirty years straight:

    By cwelsh,

    • 0 comments
    • 273 views
  • Option Terminology – Avoiding Confusion

    Options traders may easily fall into the habit of expressing ideas inaccurately. This might seem like a minor point, but in fact. It matters a great deal. Confusing and misleading language may lead to incorrect trade entry, and for those novices following more experienced traders, the use of proper terms is the whole story.

    By Michael C. Thomsett,

    • 0 comments
    • 448 views
  • Option Volatility and the Underlying

    Too often, traders may  make the mistake of associating option volatility with behavior of the underlying issue. However, if you employ a volatility assumption to model how an option is likely to change, remember that pricing models are theoretical. It is only useful for estimating the option risks. It does not indicate how underlying price will move.

    By Michael C. Thomsett,

    • 0 comments
    • 384 views
  • Before You Startup Your Own Investment Company, Read This!

    Often when we have had some success on the market, investors minds' begin to consider turning their solitary pursuit into a fully-fledged business. One that does not only line their own pockets but can help make some serious money for our client as well. 

    By Kim,

    • 0 comments
    • 677 views
  • Measuring “The Market”

    When you hear what “the market” did today, what do you think of? Most of us will think of one or more popular US stock indexes like the Dow Jones, Nasdaq, or S&P 500. But how well do these indices actually represent the total stock market? Dimensional Fund Advisors has created an excellent chart to help us answer this question.

    By Jesse,

    • 0 comments
    • 399 views
  • Managing Volatility Spreads

    Although traders often are attracted to hedged combinations (including spreads), some of the features are misunderstood. The spread may be viewed to manage risk, when in fact selection of an appropriate strategy may provide more potential when picked based on volatility.

    By Michael C. Thomsett,

    • 0 comments
    • 565 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