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 Scientific Process of Increasing Expected Returns


For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

But adding other equity asset classes to an equity portfolio, such as small cap and value, can increase diversification and expected returns at the expense of  occasional "tracking error regret". 

We will look at the period 1970-2018 in our examples. Starting with the S&P 500:

 

image.png

 

The first step will be to diversify the S&P 500 by holding US small cap stocks. We'll shift half our S&P 500 holding into the Dimensional US Small Cap Index, and rebalance annually.

 

Portfolio 2

50%: S&P 500 Index

50%: Dimensional US Small Cap Index

 

image.png

 

Our next step is to further diversify our holdings to include large and small cap value stocks. We'll again shift half our S&P 500 holdings to make room for the Dimensional US Large Cap Value Index, and half our small cap holdings to make room for the Dimensional US Small Cap Value Index.

 

Portfolio 3

25%: S&P 500 Index

25%: Dimensional US Large Cap Value Index

25%: Dimensional US Small Cap Index

25%: Dimensional US Small Cap Value Index

 

image.png

 

The effect of adding small cap and value stocks to the portfolio is an increase in annualized return from 10.2% to 12.7%, a relative increase of 24.5%. This outcome is what we should have expected to see as we added riskier small cap and value stocks to our portfolio. Therefore, we also need to consider how our changes impacted the risk of the portfolio. The annualized volatility increased from 15.1% to 17%, or a relative increase of 12.6%. This means returns increased by 24.5%, but risk only increased by 12.6%, highlighting the power of diversification.


Image result for diversification stocks bonds
 

Some investors may be more interested in using diversification to build a portfolio with less risk for a roughly equivalent return. We can do this as well by adding the stability of 5 Year US Treasury Notes to the portfolio.

 

Portfolio 4

12.5%: S&P 500 Index

12.5%: Dimensional US Large Cap Value Index

12.5%: Dimensional US Small Cap Index

12.5%: Dimensional US Small Cap Value Index

   50%: 5 Year US Treasury Notes

 

image.png

 

Compared with the S&P 500, portfolio 4 achieved a similar return with far less risk (about 40% less). The impact of this reduction in volatility is a worst year of just -12.6% vs. -37% for the S&P 500, and a maximum drawdown of 25.2% vs. 51% for the S&P 500. Another compelling statistic is the performance during "the lost decade", where the S&P 500 produced an annualized return of -1% per year. Portfolio 4 was up more than 7.2% per year during this period, more than doubling the total portfolio value. 

 

Of course, the trade off of a portfolio with 50% in low risk bonds is reduced upside potential during raging bull markets. From 2009-2018, portfolio 4 underperformed the S&P 500 by approximately 5% per year, which can cause investors to lose perspective. Since most investors are risk averse, this may be an acceptable price to pay during bull markets in exchange for much smaller losses during bear markets. 

 

The last important note is that none of the above portfolios required "active management" such as stock picking or market timing. Building an efficient passively managed asset class portfolio can be done based solely on a good understanding of the academic research highlighting the differences in expected returns among stocks and bonds.  

 

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™. 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 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

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

  • A Global Equity Put Write Portfolio

    Many that sell equity market put options focus on the S&P 500 (SPX, XSP, SPY). Some will add small caps by selling puts on the Russell 2000 (RUT, IWM). An investor could also make their put selling strategy globally diversified by adding MSCI EAFE (EFA) and Emerging Markets (EEM).

    By Jesse,

    • 0 comments
    • 240 views
  • The Random Walk Hypothesis

    The “random walk hypothesis” (RWH) is one idea about how stock prices behave – but only one of many. It is a theory promoted in academia and believed in my many, but not so much by traders involved with handling real money. Theories aside, is the market truly random?

    By Michael C. Thomsett,

    • 0 comments
    • 298 views
  • How To Trade Options Successfully

    I’ve now been trading options for over a decade and been associated with Steady Options for seven years – hard to believe.  Over that period, I’ve learned quite a bit about option trading; how to improve, what not to do, and generally how the option markets work. I’m still learning.

    By cwelsh,

    • 3 comments
    • 562 views
  • January 2019 Performance Analysis

    No one likes losing money, and no one likes hearing "excuses". However, in an effort to be fully transparent, solicit feedback, and to improve our own performance, we're writing this article to do a further breakdown of the losses which our model portfolio incurred in January 2019. 

    By Kim,

    • 17 comments
    • 1,355 views
  • Island Clusters as Strong Reversals

    Options traders constantly seek the elusive reliable reversal signal. A few unusual but strong reversals are worth looking for, and their patterns reveal likely exceptional timing for opening or closing option trades. One example of this exceptionally strong signal is the island cluster (or, island reversal).

    By Michael C. Thomsett,

    • 0 comments
    • 376 views
  • What’s Wrong With Your 401(k)? (If anything)

    There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States.  Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.

    By cwelsh,

    • 0 comments
    • 458 views
  • Upcoming Decay of Options

    I am on the hunt for a short volatility position for three main reasons. First, the market’s wild swings have, for the time being at least, diminished. Second, option activity has dried up as my options barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction.

    By Jacob Mintz,

    • 0 comments
    • 541 views
  • The Scientific Process of Increasing Expected Returns

    For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

    By Jesse,

    • 0 comments
    • 953 views
  • Those Golden and Death Crosses

    The use of moving average (MA) for predicting future price behavior must be undertaken cautiously. MA is a lagging indicator, so the question must be: Can a lagging indicator provide guidance for the future? Yes. The use of two MA lines and how they interact is a reliable form of reversal indicator.

    By Michael C. Thomsett,

    • 0 comments
    • 649 views
  • Trading Reverse Iron Condors When IV Is Elevated

    Our members know that pre earnings straddles and calendars have been our bread and butter strategies in the recent years. We enter those trades when the prices are cheap compared to previous cycles. However, in the last few months of 2018, Implied Volatility exploded, making most of those trades too expensive.

    By Kim,

    • 0 comments
    • 718 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