As regular readers will know, I’m a proponent of a very simple buy & hold, passive investing strategy. However, I do believe that there’s a value to discussing and understanding alternative strategies so that you can decide whether they’re appropriate for you. That’s why I recently invited Mark Wolfinger, author of Options for Rookies to write a guest post. He was kind enough to oblige.
Option strategies, specifically the collar strategy, can provide additional safety for your portfolio. That means a guarantee against incurring significant losses (you decide how much loss you are willing to accept–much like the deductible on an insurance policy). No asset allocation program comes with guarantees. They may come with high probability of fulfilling your needs, but that’s not as good as a guarantee.
Many of you have a negative feeling towards options and that’s understandable considering how much bad press options (or any derivative product) have received. The truth is that options were created as hedging (risk reducing) tools, and if more investors used them for that purpose, options would have a better reputation.
My specific objective today is to share why I believe passive investors can benefit by using options. General option education is available elsewhere.
There’s more to investing than choosing between passive and active management. For example, the Prudent Man Rule tells us that asset allocation and diversification are vital to reducing risk. But, the recent (technology bubble and 2008) market meltdowns have convinced many that these methods only work in bull markets.
A recent WSJ article discusses how a bunch of financial advisors have been shaken by a failure of ‘prudent’ measures. Another article tells how some advisors abandoned their traditional ideas and are now making (in my opinion) extraordinary investment decisions–in a desperate attempt to succeed. These advisors have abandoned passive investing. I’d never suggest that you do the same, but there are steps you can take to make your portfolio bulletproof. Of course, that excellent protection comes at a cost, and that cost is accepting limited profit potential and giving up the possibility of earning a substantial sum in a hurry. You still have room for growth, but it is limited.
The difficult part of investing is to find methods that provide relatively good results when markets are falling. That does not mean losing 30% when everyone else is losing 40%. It means not incurring any large losses. Ever. For the majority of investors, preventing occasional large losses is impossible and the question is: Are you confident that owning a properly diversified portfolio with assets appropriately allocated is good enough? Do you believe you are protected and can survive during bear markets, or would you prefer to own the necessary protection, knowing that your portfolio will underperform when markets are marching steadily higher?
If you are uncertain and concerned that years similar to 2008 will occur with more frequency going forward, option strategies can alleviate that concern. My host, Mike, says that good asset allocation worked last year, minimizing losses. I have no idea how well diversified portfolios performed, but the WSJ articles quoted above suggest that asset allocation did not do the job. How well did you do?
Here’s what I suggest: Continue asset allocation and diversification. But take out insurance when possible. As I explained in a recent post, owning collars underperforms significantly in bull markets and outperforms just as significantly during declining markets. (For reference, Mike’s counter-argument can be found here.)
Using collars protects your investments from serious losses. It also limits profits. Collars provide a smoother ride because the portfolio value is less volatile. Again, options are not for everyone, but insuring the value of your equity and commodity holdings by adopting a collar strategy guarantees long-term survival. Failure to use options shows a willingness to be satisfied with the (current) advice given to the Prudent Investor. Which is right for you?