Some investors believed that from the period of 1982-2000 it was their “right” to earn 10% every single year in their investment portfolios without any identifiable risk. After the 2001-2003 bear market that mentality returned. People have short memories and suffered again in the period of October 2007-March 2009. Risk showed up at our doorstep and caught everyone by surprise. Warren Buffett, George Bush and many others were on that list. Everyone is concerned about risk now. The question in the era of “the new normal” is to how to invest wisely taking risk into regard.
Asset Allocation: Everyone has heard about it but who practices it? A strict model forces one to by when everyone is selling and sell when everyone is buying. Once or twice a year at the most is the time frame to review a portfolio. A change in one’s life, be it personal, emotional, or financial are valid reasons to adjust the portfolio. But it is not enough to blindly follow a rigid formula. We incorporate our macro views to identify the markets that call for the highest concentration (and likewise the lowest). The same can be said for the fixed income world, which comes in many different flavors.
An Investment Policy Statement is essential in addressing an Asset Allocation Program. That is because we will have the information to help clients allocate to strategies that address our three legged stool of successful investing, need for capital appreciation, risk tolerance level, and liquidity issues. A lack of such a policy can take a client in a direction that he/she may dispute in the future. Whether he/she should have a conservative, moderate, or aggressive portfolio, all parties concerned should be in agreement at the beginning and throughout the relationship.
Listed Options: Options can be used to increase income with a number of strategies. One such strategy is the “collar”. The motivation behind this strategy can be for one of two reasons. The first is to take a limited risk with limited upside potential on a stock that you wish to buy. The second reason is to manage a position that may be very large for your portfolio or one that carries a very low cost basis that hopefully can avoid being sold.
Let’s take a look at a sample trade. IBM currently is trading at $155.00. One can sell a February 155 call that will expire in 30 days for a price of $2.50. The downside protection is to purchase a February 150 put for $1.25. At expiration if the stock closes at 155 or above the investor will be “exercised” and out of the position at $156.25. I took the $1.25 credit that came from the two option transactions and added that number to $155. This equates to a 10% annualized return. On the downside the the “break even” point is $153.75. The risk is limited to $150.00. Ideally the risk should equal reward, but this example is just for illustrative purposes.
Due to the current bear market many investors are underfunded. Institutional and individual investors need to squeeze everything they can out of their portfolios to make up for poor performance, but must be vigilant about not taking on to much risk. Asset Allocation, an Investment Policy Statement and suitable options strategies are the cornerstone for providing the potential for a positive investment and risk management future.
Daniel B. Stern has been an active member of the Chicago Board of Trade [http://141trading.com] since 1975 along with being a ‘seat holder’ at the Chicago Board Options Exchange from 1988-2009. He is founder and head of Stern Investment Advisors, LLC, a financial investment firm company based in Chicago. His experience as a futures trader and options trader, (along with investing his own funds and managing money for his clients) has given him the necessary background to provide clients with the tools to succeed with their financial goals.