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Unhedged exposure to SPY. Fully hedged exposure with at the money puts. Partially hedged exposure without of the money puts. And a more simple approach of reduced allocation to SPY with the proceeds allocated to an intermediate term US Treasury ETF (IEI). In the following data, I’m showing the hedged portfolios compared to the stock/bond portfolios scaled to have similar volatility. The option hedge parameters entered into the ORATS backtester targets the contract closest to one year from expiration and rolls the contracts at 45 days from expiration. The idea of going further out in time and rolling prior to expiration is to reduce the impact of negative theta (time decay) that you experience with long puts. I did not attempt to optimize the parameters that would result in the best hedging results. With the stock/bond portfolios, rebalancing is assumed to occur based on 5/25 rebalancing bands that can be replicated using Portfolio Visualizer and all results include the reinvestment of dividends. Past performance doesn’t guarantee future results. Now to the data. What we see is not surprising based on published research I’ve reviewed from multiple sources. Hedging with puts has been documented to be inefficient due to the volatility risk premium (VRP) built into option prices, making it more effective to simply lower equity allocation and use the proceeds to buy safe bonds (IEI). A stock/bond ETF or mutual fund portfolio is also much easier and less costly to manage. If buying puts produces poor long-term risk-adjusted results, it then means that selling them may produce attractive long-term risk-adjusted returns. That is the strategy we attempt to capitalize on in the Steady Momentum PutWrite service. In the AQR podcast episode “diversify or hedge?”, the hosts discuss how a portfolio of equities and cash (or safe bonds, as in my example) produces better long-term results than hedging with puts. AQR also has a research paper titled, “Pathetic Protection: The Elusive Benefits of Protective Puts” which concludes that “because of path dependent outcomes and option expensiveness, put options may do more harm than good. An alternative approach to protection that investors can take is increasing diversification. ”Hedging with puts" can still be a rational decision if an investor wants to protect from a near or complete loss of value in the stock market (and is willing to pay for it), at which point the outcomes would favor the hedging approach as opposed to the stock/bond approach. The goal of this article is to simply make investors more aware of the different choices they can make with regard to risk management and the expected outcomes related to those choices. 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, and regularly incorporates options into client portfolios. Related articles Are Bonds Still A Good Hedge? The benefits of diversification How to Analyze an Investment Strategy Equity Index Put Writing For The Long Run

Although it’s possible for such an equity portfolio to experience a decline that takes decades to recover, it’s improbable. Since we shouldn’t dismiss the improbable to be the same as the impossible, I’ll discuss how retirement investors can manage sequence risk with a moderate allocation to cash and high-quality bonds. Many examples of historical equity market data focus on a single equity index, such as the S&P 500. At my firm, we believe we can maximize the odds of earning an equity premium by investing globally instead of only holding US stocks, and by tilting the allocation within equities to known drivers of higher expected returns such as companies with low relative prices and high relative profitability. In order to simulate this type of portfolio, we’ll look at the Dimensional Equity Balanced Strategy Index from 1970 to June 2020. We primarily use Dimensional Funds to construct client portfolios. From 1970 (the inception date of the index) to June 2020, this index had an annualized return of 12.79%. To analyze the historical risk, we’ll review the 10 worst drawdowns using monthly data. A drawdown is a peak to trough decline. For example, if $100 were to grow to $150, and then drop back down to $100 this would be a drawdown of 33.33%. The following data was created with a paid account at portfoliovisualizer.com. Click on the image to zoom The average of the 10 worst drawdowns since 1970 was 27%. The average underwater period (peak to trough to new peak) was 20 months. The longest underwater period (period of time in between new highs) was less than four years. An investor who is in retirement distribution mode can use this data to inform asset allocation decisions and expectations, along with Monte Carlo simulations that generate probabilities of future outcomes by rearranging the historical monthly returns. This helps merge historical data with the reality that past performance by no means is a guarantee of future results. Assuming a 5% portfolio withdrawal rate, an allocation of 75% to the equity index along with 25% to high quality bonds and cash would provide a buffer of five years of portfolio withdrawals in safe and stable assets to draw from during a severe and lengthy bear market drawdown. Systematic portfolio rebalancing automates this process, as cash and bonds would primarily be sold when withdrawals were taken in order to rebalance back to the target 75/25 allocation. If an investor wanted to further increase their bear market buffer, a 60/40 allocation would equate to eight years of portfolio withdrawals in cash and safe bonds. Monte Carlo simulation suggests the chance of the equity index having negative returns over a 5-year period are about 5%, and the chances of negative returns over 10 years are about 1%. Portfolio allocations more conservative than 60/40 begin to introduce a different risk, which is the risk of insufficient long-term expected returns in order to sustain the desired withdrawal rate. Summary In the book Stocks for the Long Run, Jeremy Siegel concludes that “fear has a greater grasp on human action than does the impressive weight of historical evidence.” Investors could increase the odds of reaching their long-term goals by making decisions guided primarily by long-term data and probabilities than by relying on their feelings and near-term market outlook. The global equity premium is well documented and can be easily captured with low cost mutual funds and ETF’s. For those in retirement distribution mode, historical data suggests that sequence of returns risk is real, but so is the risk of low returns when maintaining excessive allocations to cash and bonds. Portfolios ranging from 60-75% in global equities have historically provided retirement investors with a nice balance of risk and expected return. 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. Related articles Coming to Peace With Market Volatility Coming to Peace With Market Volatility: Part II History is a Great Teacher 3 Principles to a Successful Investment Experience Thinking in terms of decades The benefits of diversification The Importance of Time Horizon When Investing How I Invest My Own Money Realistic Expectations: Using History as A Guide Risk Depends On Your Time Horizon

For example, since technology has been the hot sector in recent years, I regularly see portfolios that are now heavily overweight in technology stocks and sectors funds. As students of market history, we only need to look back to the late 90’s to see how concentrated sector exposure like this can potentially lead to enormous drawdowns. Academic research has shown that exposure to certain types of risks provide higher expected returns, while other risks that can be diversified away don’t provide those high returns. We should only take risks that are supported by broadly accepted academic research to have higher expected returns. My issue with TSM funds is that since they hold the entire market, including small cap stocks, I regularly find that investors believe they’re more diversified than only holding the S&P 500. This is factually true based solely on number of securities as an S&P 500 investor would currently hold 512 stocks while a total stock market investor would currently hold 3,592 (source: Vanguard). So, diversification needs to be defined. Pictures are worth more than a thousand words. Below is a chart from Portfolio Visualizer of Vanguard’s S&P 500 mutual fund VFINX (Portfolio 1) and its TSM mutual fund VTSMX (Portfolio 2) since 05/1992. This is the earliest common inception date we can analyze. Both portfolios assume the reinvestment of all fund distributions and are gross of any applicable transaction costs. You have to look closely to even be able to tell there are two equity lines plotted on this chart. The two funds are virtually identical. How can this possibly be if the TSM fund holds about 3,000 additional stocks that the S&P 500 fund doesn’t? Because TSM funds are capitalization weighted. This means that the smaller companies have such a small weighting in the fund that they don’t really even matter. Imagine you had a $100,000 account with $95,000 in Apple stock and $5,000 in Microsoft. Clearly, Apple is going to dominate the account performance. In a TSM fund, large cap stocks are like Apple, and small cap stocks are like Microsoft. In the next chart, I’m replacing the TSM fund as Portfolio 2 with the Dimensional US Micro Cap mutual fund (DFSCX). This fund holds the smallest decline (10%) of companies in the US market. This will actually show us how those smallest companies have performed differently than the largest ones that dominate both S&P 500 and TSM funds. We now see a big difference visually and in the performance measurements. We see higher volatility (Stdev) from the Dimensional fund but also higher returns (CAGR). This is what should be expected based on Nobel prize winning Fama/French asset pricing theory as well as historical evidence across the globe. The “size factor” is a source of higher than market expected returns according to Fama/French research and is explained by the unique risks associated with smaller companies. We also see that the Dimensional fund zigged and zagged differently than the S&P 500 fund. This deviations in performance create diversification opportunities when both funds are combined. Technically, a TSM fund holds these same stocks that are in the Dimensional fund, but now you understand that the minimal weighting of those stocks in a TSM fund means they have no meaningful impact. So, if smaller companies have higher expected returns and also offer diversification benefits, how much should we increase the allocation to these stocks compared to what we’d get in a TSM fund? The answer to this question depends on your personal objectives and tolerance for “tracking error.”The average investor doesn’t understand diversification very well and views the world through the lens of relative performance to the S&P 500. Viewed properly, diversification means you want different asset classes in your portfolio to perform well at different times and for different reasons. I generally recommend 20-50% in small company funds like those from Dimensional Fund Advisors for the equity portion of a portfolio. I’ll assume 40% for my last example where portfolio 2 is 60% VFINX, 40% DFSCX with annual rebalancing. This gives us enough exposure to the higher expected returns of small companies as well as their diversification benefits to actually make a difference, while also acknowledging the higher volatility of smaller companies relative to large companies so that they both contribute relatively equally to the portfolio. This is the concept known as “risk parity,” when assets are allocated based more on risk than dollars. Additional sources of risk that Fama/French asset pricing theory and historical evidence suggests leads to higher expected returns (and diversification)is the relative price of companies. For example, if two companies have similar book values and/or expected earnings, yet one is trading at a lower price than another, asset pricing theory would suggest that the company trading at a lower price has higher expected returns. This process of sorting stocks based on relative price is commonly referred to as value (companies trading at a low relative price) and growth (companies trading at a high relative price). Value stocks have historically produced higher returns than growth stocks in 84% of 10 year rolling periods in the US since 1926, and 95% of periods since 1975 in developed ex-US markets (source: Dimensional Fund Advisors). The average premium of value stocks during these periods was 3.5% in the US and over 5.1% in developed ex-US. Overweighting small and value stocks relative to a TSM fund are intelligent ways to increase expected returns without needing to time the market or pick individual stocks. Conclusion Why don’t more investors build their portfolios in line with this academically sourced research? Lack of awareness is the biggest issue…most Lorintine Capital clients do hold portfolios with varying degrees of greater than TSM weights towards small and value funds. But another reason is the term I used earlier… “tracking error” relative to commonly followed benchmarks such as the S&P 500. Small companies outperforming large and value companies outperforming growth over the vast majority of historical 10 year rolling periods is different than saying all 10 year rolling periods, and far different than outperforming over all 1, 3, and 5 year periods. We’ve seen this in recent years when any diversification away from US, large, and growth stocks has hurt performance. Those holding TSM funds have felt minimal pain since I’ve shown how that type of fund is basically the same as the S&P 500. The average investor that is unaware of the academic research and historical evidence usually thinks 3 to 5 years is long enough to make determinations of success or failure, yet academics tell us this time period is nothing more than random noise that should have absolutely no influence on long-term portfolio decisions. If anything, we see a slight tendency for a reversal effect at this 3-5 year time frame where recently underperforming asset classes become relatively cheap compared to recently outperforming asset classes, oftentimes going on to outperform at the exact time many investors sell and chase recent winners. Over the last 3 years, US large cap (S&P 500) has outperformed US small cap value by nearly 50%. A smarter approach is to build a portfolio diversified across US, developed ex-US, and emerging market stocks along with “tilts” to well-known sources of return like size and value.The extent to how much you tilt your portfolio should be based on your own personal tolerance for tracking error relative to common benchmarks like the S&P 500. A professional financial advisor that is well educated using academic research and experienced in managing the behavioral elements of investing can provide great value in this process. 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.

This is generally viewed as rational compensation for risk as investors must be enticed with higher expected returns in order to buy smaller companies that are often times in distress. In other words, it’s not a “free lunch,” although there are also behavioral arguments suggesting investors become overly pessimistic about the prospects for value companies and overly optimistic about the prospects for growth companies. When value stocks exceed expectations, and/or growth stocks fail to meet expectations, the value premium emerges. We can observe these relationships in the historical data by reviewing Fama/French and Dimensional Indices. Since 1930, there has been a 4.76% difference in annualized returns. This relationship has also been highly persistent over intermediate and longer-term timeframes. The following chart shows how often the small value index has had higher returns than the large growth index over rolling time periods. So far, we’ve only looked at US indices, so to give us additional confidence we can also look to historical data in International stock indices with data beginning in 1981. We see an even larger difference in relative returns with the International index data. This reduces the risk that the spread in returns is random chance in the historical data, along with how the effect has persisted after it was first published by Fama and French in the early 1990’s. The bar chart with rolling outperformance frequencies showed us that large growth stocks have outperformed small value stocks about a third of the time over 3-year periods. We find this to be the case since 2017, and by an abnormally wide margin. What you see is not a typo. Since 2017, large growth stocks have beat small value stocks by 26.41% per year. This is the widest margin ever over this timeframe. This massive performance gap has created the largest spreads in valuations in history by many measures, even surpassing the late 90’s technology bubble. Conclusion Academic theory and long-term historical data highlights how small value stocks have higher expected returns than large growth stocks. These relationships don’t always materialize over shorter periods of time, such as 3 years, otherwise there would be no risk. Readers who strongly believe in the equity premium should also consider that stocks have underperformed risk-free Treasury Bills more than 20% of the time over 3-year periods, and about 13% of the time over 10 years. Again, risk and return are related and discipline is required. Since 2017 small value stocks have dramatically underperformed, testing investor discipline, while at the same time creating future opportunity. Spreads in valuation between large growth stocks are at records relative to small value stocks. Since valuations are one of the most reliable indicators of future performance that we have, it may be more likely than usual that small value stocks outperform large growth stocks. When uncertainty is elevated, such as today due to economic pressures from the global pandemic, investors may demand an even larger expected risk premium for small value stocks that are out of favor compared to big glamorous growth companies that are fun to brag to your friends about owning. So, what should you do? If you currently have little or no exposure to this category of the market, now may be a good time to consider adding it to your portfolio. If you already have greater than market cap weighted exposure like I do, it’s probably a good time to check your portfolio because the spread in recent performance may require you to rebalance back to your target allocation. This would involve trimming large growth exposure and using the proceeds to add to small value. Of course, it’s impossible to predict when things will change, many smart people have been calling for the relative performance bottom in small value stocks for months now, and for this reason you should only consider changing your portfolio if you see the “value” in small value and you’re willing to stick with it for the long run. 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. Related articles Understanding Growth Vs. Value Stocks History is a Great Teacher The Best Chart I’ve Seen in 2020 Realistic Expectations: Using History as A Guide The Value of Equity Asset Class Diversification Total Stock Market Index Funds: A Diversification Illusion?

I’ll explain all three in this article, along with examples. The best part is none of this is overly complicated and can largely be automated with recurring ACH transfers, systematic fund purchases, and rebalancing software. I recommend financial plan automation to the maximum extent possible, as this minimizes the chances we'll overthink our purchase decisions by trying to time the market. Asset allocation Asset allocation is your portfolio mixture of stocks, bonds, and cash. In order of lowest expected risk and return to highest is cash, bonds, and stocks. Your allocation to cash should be based on your short term liquidity needs. Keeping a month or two of living expenses in your checking account, and another three to six months in a high yield savings account or money market mutual fund should round out the majority of your cash position most of the time. Cash is also sensible for any lump sum expenses coming up in the next year (large tuition payment, car purchase, etc.). Expenses coming up in the next 2-5 years can be held in FDIC insured CD’s or bond funds of similar maturity as this appropriately reflects the time horizon of the money. I recommend only investment grade bond mutual funds or ETF’s. Beyond 5 years, your decision to include fixed income in your portfolio (CD’s or bond funds) becomes more of a risk tolerance decision than a financial planning decision. It would be reasonable to consider keeping all dollars with an expected time horizon of greater than 5 years in diversified equity funds, but not everyone has the stomach for the associated volatility even when they know they don’t need the money for several years. For this reason I recommend using the following table to guide that decision, where your maximum tolerable loss helps determine your equity allocation, with the difference going into fixed income funds. Source: “Your Complete Guide to a Successful and Secure Retirement” by Larry Swedroe and Kevin Grogan. Diversification Diversification is your allocation across all publicly available stocks and bonds. Instead of just buying a handful of your favorite stocks, or even buying just the S&P 500 which represents US large cap stocks, practice smart diversification by investing globally. For US investors, a good mix is around 65% US, and 35% World Ex-US stocks. Do this with low cost index funds that capture the total market return. Within stocks, an advanced concept is to add additional weight to stocks with higher expected returns, such as small cap and value stocks. For example, from 1930-2019 the Dimensional US Small Cap Value Index outperformed the Fama/French Total US Market Research Index by 3.98% per year. For those who are skeptical about this datapoint, consider the frequency at which the small cap value index outperformed the market index over all rolling 10-year periods (90%) was higher than the frequency of the total market index outperforming risk free one-month US treasury bills (87%). Both the total market premium over T-bills and the small value premium over the market can be explained as rational compensation for taking more risk. Academic research has concluded that small cap and value stocks have unique and independent risks from the market, and these risks result in these types of stocks having higher expected returns. On the bond side, global diversification is also beneficial, and fund companies like Vanguard offer global bond mutual funds and ETF’s worth considering as a simple one fund solution. My firm uses funds from Dimensional Fund Advisors, but these funds are only available through financial advisors. There’s usually no reason your total portfolio needs to consist of more than about 5-7 funds. Arguments for a few more or a few less can be made, but portfolios of a dozen or more funds are probably overly complex. Rebalancing This is the last core principle to long-term success. Rebalancing is the act of bringing your portfolio back to your targeted allocations on a periodic basis. This can be done systematically based on the calendar (such as annually) or based on tolerance bands where you assign a minimum and maximum allowable percentage range for each fund in your portfolio to drift, which you review monthly or quarterly. For example, if you had an equal 50/50 allocation to two different funds, differing performance between the funds will cause the allocation to drift over time to where you’ll need to sell some of the fund(s) that has become overweight relative to your target and use the proceeds to buy some of the fund(s) that has become underweight. If your portfolio has a mixture of stock and bond funds in it, this will keep the volatility of your portfolio in line with your objectives outlined in the asset allocation section. For taxable accounts, it makes sense to rebalance with cash flows when available in order to minimize taxable events. If you’re regularly contributing new money to your account, you can apply it to funds that are underweight. Additionally, you can apply dividends paid in cash towards funds that have become underweight. For employer retirement accounts, check to see if automated rebalancing is a feature available within your plan. Conclusion Good financial planning and portfolio management is not particularly difficult, and there has never been a better time to be an investor from the standpoint of having access to funds that cover stocks and bonds all over the world. But the process does require a lot of upfront knowledge and discipline, especially during extreme markets like we’ve seen so far in 2020. As the cartoon character Pogo said, “we have met the enemy, and he is us.” If the entire process still seems more complicated than you’d prefer, or if you’d simply like a second opinion from time to time, contact an independent fee based financial advisor that can help you construct a well thought out plan in line with these principles for either an hourly fee or based on assets under management. My firm can provide both service models to individuals, and we offer a complimentary 15-minute phone call to determine if we might be a good fit for your needs. 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, and regularly incorporates options into client portfolios. Related articles What Is True Diversification? The Benefits Of Diversification Should You Hedge Or Diversify? The Value Of Equity Asset Class Diversification Coming To Peace With Market Volatility Coming To Peace With Market Volatility: Part II

The important point is that these lessons are simple and can be systematized so that in real-time you can simply follow your well-designed plan without having to interject human judgement which is often heavily influenced by emotion and short-term performance. For example, below are the net returns of four funds representing four distinct equity asset classes from 1995-1999. This example is meant for illustrative purposes only, and past performance doesn’t guarantee future results. Notice the stark differences in performance during this time period. US equities dominated both International and Emerging Markets, especially US Large Cap compared to International Small Cap Value. Considering that the average investor instinctively thinks five years is a long enough period of time to evaluate performance, what do you think he or she might feel like doing at this point? Certainly not rebalance the portfolio back to its original weighting by selling a material amount of SPY to buy DISVX. That would feel backwards, but it’s an important part of successful long-term investing. Let’s now look at the next decade, from 2000-2009, to see why. What a contrast. From 2000-2009, US Large Cap actually produced a loss and International Small Cap Value produced the largest gain. Since most investors are over concentrated in US Large Caps, it explains why this period is referred to as “The Lost Decade.” This clearly wasn’t true of all stocks in the US or the rest of the world as we can see. Investors who abandoned diversification in 1999 would have experienced a lot of pain in the 2000’s, while the average of the four asset classes was more than double the starting value. Let’s now put the entire 1995-2009 period in context and also highlight the power of rebalancing. During this entire period, we see all four asset classes produced strong results with the average growth of $100,000 being $369,560. In other words, if an investor put $25,000 into each fund in 1995 and did absolutely nothing, the investment would have been worth $369,560 at the end of 2009. This is a compounded annual return of 9.11%, which highlights the power of equity investing. Yet you’ve probably noticed I’ve added one additional line item to highlight the benefits of rebalancing a portfolio. The rebalancing rule is as follows: Each month, review if any of the funds have drifted by a relative 25% from their target weightings. Since we are targeting 25% in each fund in this simple illustrative example, that means you would rebalance anytime a fund has drifted by more than 6.25% from the target 25% allocation. In other words, as long as each fund’s current weight is between 18.75% and 31.25%, you do nothing. During this period of 1995-2009, you would have rebalanced only eight times. But as we can see, rebalancing would have added more than $45,000 to the portfolio, increasing the compounded annual return to 9.95%! This is more of a “rebalancing premium” than we should expect over the long term, which is no surprise since I intentionally picked funds and a time period for this article to emphasize a point. Vanguard has expressed in its “advisor’s alpha” concept that a good advisor can add “about 3% per year” of value to a client’s situation of which 0.35% per year is estimated to come from disciplined rebalancing. This rebalancing premium is intuitive when we stop and think about it, as it forces us to “buy low/sell high.” Conclusion Human nature is a failed investor, and the best way to overcome the most common investor mistakes is with a well thought out evidence-based plan that incorporates the important concepts of equity asset class diversification and disciplined rebalancing. Working with a financial advisor who intimately understands these concepts can help improve the odds of a successful long-term 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, and regularly incorporates options into client portfolios. Related articles Cash Is (No Longer) Trash Investment Ideas For Conservative Investors The Importance Of Time Horizon When Investing Steady Momentum ETF Portfolio Equity Index Put Writing For The Long Run

Every trader knows that trades can move against a position. With wise analysis and careful selection, the market risks can be reduced. But if all your options are written on stocks in the oil and gas sector, or retail, or Internet companies, a sector-wide downward cycle could hurt all your positions. Options traders, like all traders, will improve their success and reduce market risks by being aware of the need for diversification in terms of market sectors, specific companies, options strategies, and timing of trades with many other things in mind (ex-dividend date and earnings announcements, for example). Diversification is not well understood. To many, simply buying shares of several different companies is adequate. However, if all those companies are subject to the same market and economic forces, are you truly diversified? Of course, you are not. It’s more than just expansion of sectors that defines true diversification. Many dissimilar sectors face the same types of market risks. To diversify, you need to diversify market risks. This means options traders need awareness of cyclical forces for companies, not just for options strategies. For example, if you own shares in four of the major oil companies, all of them are going to rise and fall due to the same changes in the market, commodity price, OPEC decisions, and more. This is not diversification; in fact, it is just the opposite, a concentration of capital in a narrow area. Some options traders, aware of the leverage options provide, tend to ignore this and to fall into the belief that market forces for a company do not affect the valuation of options or the change in option premium. Just as stock investors experience varying levels of market risks, options traders do as well. It is important to be reminded that options are called derivatives because their value is derived from movement in the underlying security. This means there is a direct relationship between historical volatility and option valuation. Many traders ignore historical volatility, favoring implied volatility (IV) of the option. But this tests and predicts option volatility alone and not the underlying volatility. Because IV is based on estimation, it is less reliable for diversifying risk than the more precise measurement of historical volatility. For many devoted options traders, the suggestion that implied volatility should not be considered in assessing risk is a form of heresy. But it is a rational point to make. Here’s the point: If you are not diversified, market risk can have an immediate and negative impact on your options trades, no matter how much prediction from IV is involved. Even if you accurately estimate future IV, a key point to keep in mind is that IV forecasts levels of risk, but not direction of price movement. An option may react to stock prices in a low or high volatility level; but IV measures degrees of change, not whether prices move up or down. To some traders, this comes as a surprise. A popular assumption is that tracking IV allows a trader to predict whether to be bullish or bearish. It does not. Diversification is not the answer, any more than estimating volatility ensures well-timed trades in the right direction. A lack of diversification exposes traders to market risk which might be greater than their risk tolerance finds acceptable; and that is the problem. If you could find “sire thing” in an options trade, you would not have to worry about diversification. It would be possible to put all your money in a single trade and just collect profits. Is this an unlikely scenario? Not at all. For example, many covered call traders believe they are not exposed to risk in any form. These are foolproof trades. The truth contradicts this assumption. If the underlying price falls below your adjusted basis (price of stock minus option premium received), you have a paper loss and you must either wait for the price to recover or look for a recovery strategy. On the upside, maximum profit is limited to the premium you received for selling the call, meaning the lost opportunity of a rapidly advancing underlying price should be kept in mind as well. Covered calls are not foolproof, meaning the need for diversification must be expanded beyond spreading money around among different companies. It also requires diversification of options strategies and risk exposure. The lack of diversification is subtle. For example, owning shares of different companies not in the same industry may be equally non-diversified. Just because a portfolio consists of stock in companies of different market sectors, does not mean the portfolio is diversified. By the same observation, limiting yourself to only one strategy represents an equally serious form of non-diversification. For example, if all you write is a series of covered calls, a marketwide bull trend could lead to exercise of all your positions – and to significant lost opportunity. True diversification takes many forms. If you limit the form of diversification to stocks, make sure the sectors involved are not subject to the same influences. Don't overlook cheaper and often forgotten stocks, either. Your profit potential can be enhanced with quick and easy ideas for these companies. Beyond direct ownership of stocks, you can diversify by: Buying shares of ETFs or index funds and writing options on those positions. Diversifying by degrees of risk, for example combining selection of strong value investments with less speculation in more volatile growth stocks, again opening covered options on this portfolio. Combining stock ownership with option speculation, exposing you to potential capital gains from market activity along with current income. Dividing a portfolio among stocks, bonds, commodities and real estate. (And by the way, you can invest in any or all of these without owning directly, if you seek a specialized ETF with ease of trading and built-in diversification within each ETF). Trading options in place of stocks for maximum leverage and risk reduction, and opening calendar spreads to hedge market risk in existing equity positions. In summary, just be sure that the various baskets contain different kinds of eggs. Most traders and investors know better than to put all their eggs in one basket, but if you are carrying all the baskets at the same time and you trip, don't all the eggs break? Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

This type of rationale can also be applied to the equity markets with the size and value factors. Fama and French wrote about this nearly 30 years ago, with the implications being implemented by Dimensional Fund Advisors (DFA) and others in the financial industry. Many investors don't maximize the diversification benefits that are available in the equity components of their portfolios. Diversification is often thought of primarily as a stock/bond allocation decision, but there is more to it. Market cap weighting means that even a total stock market fund is still nearly identical to the S&P 500. Whether it's large or small stocks, growth or value, domestic or International...bear market correlations do generally (but not always) rise in equities (meaning they all tend to decline at the same time). But there is more to diversification than just the temporary declines associated with bear markets. Let's look at a simple example: 1990-1999: S&P 500 annualized return: 18.21% DFA Equity Balanced Strategy Index: 13.71% 2000-2009: S&P 500 annualized return: -0.96% DFA Equity Balanced Strategy Index: 7.40% 2010-2018: S&P 500 annualized return: 12.75% DFA Equity Balanced Strategy Index: 10.44% 1990-2018: S&P 500 annualized return: 9.93% DFA Equity Balanced Strategy Index: 10.88% The S&P 500 may indeed be a passive index, but only (or heavily) allocating to it for a portfolio is indeed an active decision since it only represents US large cap stocks. It almost certainly should be a part of a well diversified equity portfolio, but so should small cap and International equities. Tilts towards small and value may also offer investors a return premium, or at minimum, diversification benefits. The starting point for an equity investor should be a globally diversified portfolio as a sensible way to earn the equity risk premium. 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 is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.

Since June of 1986, they've both carried Sharpe Ratio's of approximately 0.5. Sharpe Ratio measures excess annualized return / annualized volatility. Excess return is the annualized return of the mutual fund minus the risk free return of T-bills. Portfolio 1 = VFINX Portfolio 2 = VUSTX We see that VFINX had a higher return, but also higher volatility. This is what we would expect over a long period of time from relatively efficient markets. And we'd also expect similar Sharpe Ratio's like we see. So what's the benefit of diversification? Well, a risk parity portfolio, where both assets contribute about the same amount of volatility, would mean we need about 40% in VFINX, and 60% VUSTX. Portfolio 1 = 40% VFINX, 60% VUSTX We immediately see the benefits of diversification where the 40/60 portfolio Sharpe Ratio shoots up to 0.73. That's substantially higher than either mutual fund itself, and even higher than Warren Buffett during this same period where BRK/A produced a Sharpe of 0.64. This means the benefits of diversification are making a portfolio more efficient by offering higher returns per unit of risk. Are you thinking right now, "yeah, but the return is still less!". That's true, and it's why I often find investors believe that diversification lowers returns. This ignores the ability to use leverage. Let's assume in the following examples that we can borrow at the risk free T-bill rate. This is unrealistic, but the futures market does provide implied financing rates relatively close to this over time. With the ability to use leverage, either by borrowing funds directly through a source of financing such as a bank or a margin loan from a broker (i.e., Interactive Brokers), or indirectly through derivatives like futures and options contracts, we are no longer constrained to investing a maximum of 100%. This means we can use the benefits of diversification to either A. produce similar returns with less risk or B. produce higher returns with similar risk. A. Similar returns (as 100% VFINX) with less risk by investing 25% more in each fund (50% VFINX, 75% VUSTX). Financed at the T-bill rate. B. Higher returns (than 100% VFINX) with similar risk (defined as "Stdev", or annualized volatility) by investing 100% more in each fund (80% VFINX, 120% VUSTX). Financed at the T-bill rate. These examples are meant to be just that...examples. Leverage creates risks of its own that investors should be aware of, but I personally like the benefits of using moderate amounts of leverage applied to a diversified portfolio to increase expected returns, vs. the more conventional method of simply investing more in stocks. To each his own. I mentioned that we'd compare the results of our leveraged portfolio to that of Warren Buffett's (via BRK/A). So let's take a moment to do just that...interestingly enough, academic research has concluded that a material amount of Buffett's outperformance was due to just that...leverage...1.6X on average. "Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks." Portfolio 1 =BRK/A Portfolio 2 =80% VFINX, 120% VUSTX Our 2x levered portfolio slightly underperformed BRK/A on an absolute return basis, but slightly outperformed on a risk adjusted return basis due to having approximately 30% less volatility. The risk here for retail investors is when the thought crosses their mind "well, if I can lever up to 200%, why not MORE ?" Hopefully I don't have to explain the risks of leverage...just because you can drive a Ferrari 200 mph doesn't mean you should! A rule of thumb is that if you model your portfolio annualized volatility to be more than ~20%, you're probably driving too fast and eventually you're going to crash. For this reason, only highly sophisticated and highly disciplined investors with a strong understanding of modern portfolio theory, statistical probabilities, and quantitative finance should attempt to create portfolios like this on their own. There are many variables to consider, and it's never as obvious as it looks. "You've got to guess at worst cases; no model will tell you that. My rule of thumb is double the worst you have ever seen" - Cliff Asness, AQR "Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there is pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe Ratio of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe Ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need." - Cliff Asness 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 oversees the LC Diversified forum and contributes to the Steady Condors newsletter.

Of course we all know that CNBC's first priority is to increase rating to sell advertising, not to make you money. But this is a separate topic. What is diversification? According to Investopedia, diversification is "A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated." According to Warren Buffett, "Put all your eggs in one basket and then watch that basket very carefully. Diversification is Protection against Ignorance" - which means that you diversify when you are not sufficiently confident to bet on which asset (or asset class) will do well and which will do poorly. According to Mark Cuban, "Portfolio diversification is for idiots. You can't diversify enough to know what you're doing. You've got to do your homework and play your best bets" According to Jason Sweig, "For anyone with a sustainable ability to identify the hottest investment of the moment, diversification is a mistake. But if you really believe you've got that ability, you're not just mistaken. You need to be hauled off in a straitjacket to the Institute for the Treatment of Investment Insanity. But when it comes to investing, there's only one sure bet: that sure bets don't exist." So who is right? Let's say you owned a nice diversified portfolio at the end of 2007. How would it help you? AAPL declined 60% from $200 to $80. CSCO declined 60% from $34 to $14. C declined 98% from $55 to $1. GOOG declined 66% from $750 to $260. GE declined 85% from $42 to $6. F declined 90% from $10 to $1. Of course many of them recovered, but would you know to buy them at the bottom? And some of those stocks are still trading below 2007 levels. But here is the biggest problem. As Bespoke Investment Group correctly point out, "One of the problems with diversification is that during times of turmoil, asset classes tend to become highly correlated, defeating the purpose of the diversification in the first place. This was especially true during the financial crisis in late 2008 when hedge funds and other asset managers were hit with massive redemptions. This caused even a safe haven like gold to fall along with everything else." Diversification works well during bull markers, because securities tend to have low correlation - some of them will zig when others zag. But during bull markets you don't really need to be diversified - most stocks will go up anyway, or you can just buy a broadly diversified ETF lile SPDR S&P 500 Trust ETF (NYSEARCA:SPY). But when a bear market arrives, all stocks start to move in the same direction. Just when diversification is needed the most, most stocks become highly correlated. What is the solution? As we always say, you can't control returns, only manage risk. I really dislike when people make trading sound like if you are really good at it you somehow have control over your returns. The only thing you can do is build a winning strategy (better yet, multiple winning strategies with low correlation) and then manage your risk and position size so that you stay in the game long enough to let your edge work out over the long term. No single strategy is the holy grail. The key to long term success is to build your portfolio based on few different strategies with low correlation. Owning 20-30 different stocks from different industries is not diversification. "By adding short and hedged investments to a portfolio in a systematic way diversification is significantly increased. 2008 is a recent historical example where a global sell-off can cause correlations among asset classes to reach unusually high levels. When virtually every major asset class goes down, a portfolio diversified only by owning different asset classes can still experience large losses that can cause many investors to abandon their long-term plan. Diversifying across strategies helps mitigate this risk. The idea of a diversified portfolio is not to beat a benchmark like the S&P 500. Diversification is about building a portfolio for the maximum potential return with the least risk. Diversification is about creating the most consistent equity curve possible. In Geek Speak, we're talking about maximizing our Sharpe Ratio. To do that, diversification requires unrelated strategies. Unrelated strategies ensure that in the short term there will almost always be something in your portfolio that you love and something that you hate. Creating a robust portfolio is a form of 'alpha' in itself." - Jesse Blom Want to join our winning team? Start Your Free Trial