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

  • Important Tips For First Time Currency Traders

    Diversifying your portfolio is important for all investors, and currency investments are a great way to do that. However, there are a lot of misconceptions and common mistakes that first time currency investors make, and this leads to big losses.

    By Kim,

    • 0 comments
    • 43 views
  • Iron Condors or Short Strangles?

    In my early option trading days, I favored selling iron condors over selling strangles. I thought that selling a strangle was too risky because the potential loss was “undefined”. I thought this made sense because this is what I’d hear from other people that were more experienced than I was.

    By Jesse,

    • 0 comments
    • 1,131 views
  • How To Be A Successful Day Trader From Home

    The good news is that if trading is your passion, then it’s possible to become a successful day trader and work from home. However, it’s not as easy as setting up shop and jumping online. There are specific steps and processes you need to have in place if you’re going to be able to make a living for yourself and have a bright career and future.

    By Kim,

    • 0 comments
    • 142 views
  • 3 Key Pieces Of Advice For New Traders

    These days, everyone claims to be an ‘expert’ on absolutely everything. Apparently, it only takes having a Twitter account to be a seasoned expert on any given subject; all in all, the Internet is full of nonsense. It’s becoming harder and harder to find legitimate answers amongst the quagmire of false information online.

    By Kim,

    • 0 comments
    • 207 views
  • Why New Traders Fail

    Our first advice to new traders is: "Learn First, Trade Later". The markets will always be there, but if you start trading without proper fundamentals, your capital will be gone very fast. The barrier to enter trading is so low today, commissions are near zero, and the whole trading game looks very promising.

    By Kim,

    • 0 comments
    • 400 views
  • Lumpy Dividends and Options

    Dividend payments, like oatmeal, may be smooth or lumpy. Smooth dividends are predictable, usually once per quarter. It is easy for options traders to believe these dividends are guaranteed, because they usually continue uninterrupted quarter after quarter. This also makes it easy to predict total return over a longer time span.

    By Michael C. Thomsett,

    • 0 comments
    • 378 views
  • Coming to Peace With Market Volatility: Part II

    On April 18th I wrote part I of this article, Coming to Peace With Market Volatility. I showed how the US equity market risk premium, defined as the annual average return of the Total Market minus the return of one-month US Treasury Bills, was a large 8.37% per year from 1950-2019. That’s the good news.

    By Jesse,

    • 0 comments
    • 412 views
  • Ratio Calendar Spreads

    The ratio calendar spread is well-known to some, but for others the risk/reward aspects are not well understood. One way to cover a short position is to own 100 shares of the underlying stock. Another, more creative way is to sell a shorter-term expiration position and buy a longer-term position.

    By Michael C. Thomsett,

    • 0 comments
    • 822 views
  • Studies Vs. Real Trading

    "Who you gonna believe, me or your lying eyes?" Our members and readers know that buying pre earnings straddles has been one of our favorite strategies that produced consistent gains in the last 8 years with very low risk. Yet there is a significant number of studies showing that this strategy has a negative expectation. 

    By Kim,

    • 0 comments
    • 768 views
  • Should You Hedge or Diversify?

    Using the most popular S&P 500 ETF (SPY) to represent the US stock market, this article will look at different ways to manage equity market risk using historical ETF and options data from ORATS Wheel since 2007. We will analyze the following unhedged, hedged and allocation choices:

    By Jesse,

    • 11 comments
    • 1,137 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs Expertido