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

  • 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
    • 145 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
    • 115 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
    • 1,275 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
    • 782 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
    • 808 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