Archives for September 2011

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Should I Use Options?

Joseph writes in to ask,

“I recently read about using stock options to reduce the amount I lose when stocks fall. It sounded like a good idea, but I’ve read elsewhere that options are very risky. Who’s telling the truth? And should I be using options?”

Before answering Joseph’s questions, let’s take a step back and briefly cover the very basics.

How Do Options Work?

There are two basic types of options: calls and puts.

A call is a contract that gives you the right to buy something at a specific price (the strike price) any time between now and a specific point in the future. For example, you could buy a call that would allow you to buy 100 shares of Apple at $400 per share any time in the next 30 days.

A put is a contract that gives you the right to sell something at a specific price any time between now and a specific point in the future. For example, you could buy a put that would allow you to sell 100 shares of Apple at $350 per share any time in the next 30 days.

To buy a put or a call contract, you pay a price known as a premium. The more of a long-shot the option is, the lower the premium will be. (For example, buying a call with a strike price $10 above the stock’s current market price will cost less than a call with a strike price $5 above the stock’s current market price.)

Alternatively, rather than being the one to buy either of those options, you could be the one to sell them. That is, in exchange for receiving the premium (the price of the option) you’d be giving somebody else the right to buy shares from you (in the case of a call) or sell shares to you (in the case of a put) at a specific price any time before the option expires.

In addition, you can combine calls and puts (and the buying and selling of each) in various ways to create specific bets — a bet that a given stock will either fall by more than 10% or go up by more than 10%, for example.

Are Options Risky?

Options are not inherently risky. Rather, the riskiness depends entirely on what type of option strategy we’re talking about.

For example, if you buy a call option with a strike price that’s far above the stock’s current market price, the most likely outcome is that the option expires without ever being exercised. In other words, the most likely outcome is that you lose all the money you spend on the option.

Alternatively, options can be used to reduce risk. For example, if you owned shares of Vanguard Total Stock Market ETF, you could buy a put for that ETF that would effectively limit your maximum loss in the event of a market downturn.

Should I Be Using Options?

While options can achieve helpful outcomes, there’s usually an easier way to do it.

For example, if you want to reduce the risk in your portfolio, it’s easier to just modify your asset allocation to include more cash and/or bonds rather than continually purchase put options for each of your holdings. (Remember, options expire, so you’d have to purchase new ones regularly in order to maintain the protection you want.)

There are some circumstances in which options play a role that nothing else really can. For instance, if a high portion of your net worth is in a given stock that, for one reason or another, you’re not allowed to sell, you may be able to reduce that risk by buying puts on that stock (if you’re allowed to) or on a security that’s likely to move in a similar direction to that stock.

In other words, options are not inherently risky. Nor are they inherently bad. They have their uses. It just so happens that for most individual investors, those uses are few and far between.

Who Is Your Money For?

Most people I talk to have two primary goals for their retirement savings. First and most obviously, they want their savings to last them the rest of their lives. Second, they hope to leave behind something for their kids/grand kids/other loved ones.

At first glance, these goals seem almost indistinguishable: If you don’t run out of money during your life, there will be something left for your heirs. And efforts that serve one goal tend to simultaneously serve the other goal. For example, if you cut your annual spending, you reduce the chance that you’ll run out of money, and you increase the amount of money your heirs are likely to receive.

Competing Retirement Goals

What many investors don’t intuitively grasp, however, is that in some cases, these two goals are in direct competition with each other.

For example, if you allocate a significant portion of your portfolio to an inflation-adjusted lifetime annuity, you create a source of income that will last the rest of your life (insurance company default notwithstanding). Such products can be a great way to reduce the chance that you’ll outlive your money.

At the same time though, they eliminate the chance that the annuitized money will outlive you. When you die, the money that you put into the annuity is gone — your heirs don’t get any. (Possible exception: You can pay for a rider that allows your heirs to continue receiving payments for a certain length of time. The drawback, of course, is that such riders reduce the payout on the annuity.)

Waiting until age 70 to claim Social Security works the same way: By increasing your monthly benefit — a source of income that will last the rest of your life — you reduce the chance of running out of money. But when you die, your children don’t continue receiving benefits (unless they’re under 18, under 20 and in high school, or disabled).

Selecting an asset allocation for your portfolio involves a similar trade-off. By using a conservative asset allocation in which TIPS are the largest component, you reduce the chance of unexpectedly-poor returns forcing you to deplete your portfolio prematurely. In exchange, you give up the possibility of unexpectedly-good returns creating a large inheritance for your loved ones.

In short, by making decisions that increase the risk and expected return of your savings, you tend to increase the amount that your heirs would be expected to receive. At the same time though, you’re increasing the chance of depleting your portfolio while you’re still alive.

Balancing these two goals is naturally a personal choice — nobody but you can decide the relative importance of each goal. But it’s important to be aware that the two goals do often compete with each other, and just because a particular course of action serves one goal doesn’t necessarily mean it serves the other.

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Shifting Bond Maturities and My Latest Mistake

When interest rates rise, bond prices fall. Because today’s interest rates are extremely low, some investors worry that interest rates could rise sharply in the future, thereby causing bond prices to fall sharply.

One method of protecting yourself from such an event is to shift your bond allocation from longer-term bonds to shorter-term bonds.

The reason this would offer you some protection is that when market interest rates rise, a bond’s price (or bond fund’s price) will fall by an amount approximately equal to its duration, multiplied by the increase in interest rates. For example, if a bond fund has an average duration of 3 years, and interest rates rise by 1%, the fund’s price will fall by approximately 3%.

Therefore, if you shift from one bond fund to a shorter-term bond fund of similar credit quality, the amount of protection you’d gain is approximately equal to the difference in the funds’ respective durations, multiplied by the increase in interest rates that eventually occurs.

For example, if all interest rates rose by 2% tomorrow:

  • Vanguard Total Bond Market Index Fund (average duration = 5.2 years) would fall by approximately 10.4% (5.2 x 2%), while
  • Vanguard Short-Term Bond Index Fund (average duration = 2.6 years) would only fall by approximately 5.2% (2.6 x 2%).

On the other hand, because shorter-term bonds have lower yields than longer-term bonds, you’ll be earning less interest in the interim. To continue our example, according to Vanguard’s site, the difference in yield for the two funds above is currently 1.67%. So if rates go nowhere, the cost of shifting to the shorter-term fund would be approximately 1.67% per year in forgone interest.

My Experiment with Shifting Maturities

When I first created my index fund portfolio, it looked like this:

  • 40% Vanguard Total Stock Market Index Fund,
  • 40% Vanguard FTSE All-World Ex-US Index Fund,*
  • 10% Vanguard REIT Index Fund, and
  • 10% Vanguard Intermediate-Term Treasury Fund.

In November 2010 though — while making an IRA contribution and rebalancing our portfolio — I moved from the Intermediate-Term Treasury fund to Vanguard’s Short-Term Treasury Fund in order to pursue the strategy described above. Interest rates were very low, and it seemed clear to me that they’d be increasing at some point.

But with the help of some members of the Bogleheads forum, I eventually realized my plan was poorly conceived:

  • I intended to move back to the Intermediate-Term fund at some point, but I had no specific plan for when to do so. I was just making it up as I went along;
  • I had absolutely no idea how long it would take before interest rates would rise; and
  • As somebody who makes a conscious effort to ignore economic news (hence the name of this blog), it’s likely that I wouldn’t even notice when interest rates eventually did reach a more historically-normal level.

After mulling it over for a couple months, I finally moved back to the Intermediate-Term Treasury Fund. This time I plan to stay put.

Why am I telling you this?

Admittedly, in my particular case, this mistake was rather trivial. It was only 10% of my portfolio, and it was a shift from one type of bond to a mostly-similar, lower-risk type of bond.

Still, it was a poorly reasoned decision, and hopefully we can draw a lesson from it.

That lesson: It’s easy to make observations about current market conditions (e.g., “by historical standards, interest rates are unusually high/low” or “by historical standards, stocks are expensive/cheap”). But interest rates can stay low (or high) and stocks can stay cheap (or expensive) for a very long time. And unless we can predict when things will change, it’s difficult to draw much benefit from such observations.

*This has since been replaced with Vanguard Total International Stock Index Fund. At the time I created my portfolio, the Total International fund had a higher expense ratio, but that’s no longer the case.

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