Ignoring the Noise

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.

September 14, 2011 6 comments

I’ve mentioned before that, if there’s one thing from the academic world of finance that I think more investors should know about, it’s the concept of market efficiency.

To provide some background information: In an efficient market, the current price of each investment would reflect all known information about that investment.

In other words, in an efficient market, all public information would already be reflected in a stock’s price, so there would be nothing to gain from looking at financial statements or from paying somebody (i.e., a fund manager) to do that for you. Similarly, there would be no benefit to trying to time the market by determining whether the market as a whole is underpriced or overpriced.

Volatility and Market Efficiency

Many investors look at periods of market volatility and ask how such things could happen if markets were efficient. That is, how could the price of the market have been correct a month ago, and be correct today even though it’s 10% lower?

As explained by Eugene Fama:

“The market can only know what’s knowable. … When there’s a large amount of economic uncertainty out there, there’s going to be a large amount of volatility in prices.”

In other words, efficient markets only reflect currently-known information. When previously-unknown information becomes available, market prices change accordingly. If that new information is surprisingly bad or surprisingly good, market prices will change dramatically and suddenly.

That’s how an efficient market should work.

Is the Stock Market Perfectly Efficient?

For the record, I don’t believe the stock market is perfectly efficient all the time. There have been a handful of investors throughout history who appear to have successfully identified inefficiencies that they could reliably exploit for profit. (And there could certainly have been more who succeeded in keeping their identity and methods a secret.)

That said, for most investors, myself included, it’s not worth the time and money to try and seek out inefficiencies, because:

1. They’re hard to find (and they may disappear soon after being found if other investors find out about them as well), and
2. Even if you think you’ve found one, it may turn out to have been nothing other than randomness, and if you bet heavily on it, you could end up in a heap of trouble.

Similarly, it’s no easy task to find a fund manager who will reliably outperform the market. In order to do so, you’d have to identify an inefficiency in another mostly-efficient market: the market for fund management skill.

August 31, 2011 5 comments

From time to time, I hear people suggest that if you’re an aggressive investor you may want to use actively managed funds rather than index funds–the reason being that actively managed funds have the potential to outperform their benchmarks, whereas index funds do not.

That line of thinking is nonsense.

To back up a step: The goal of aggressive investing is not just to increase risk, but to do so in order to increase the expected return of your portfolio.

And as we’ve discussed before, if you switch from low-cost index funds to higher-cost actively managed funds, you actually reduce the expected return of your portfolio–unless, that is, you have a method for reliably picking above-average funds. (I have yet to see such a method, but I’m willing to hypothesize that somebody out there has one.)

But let’s go ahead and point out the obvious: If you have such a method, wouldn’t it make sense to use it regardless of whether or not you’re an aggressive investor?

To recap:

• If you have a reliable method for picking top-performing active funds, you should use it.
• If you’re like the rest of us mere mortals (and you don’t have such a method), you should stick with index funds or similarly low-cost ETFs.

It’s got nothing to do with risk tolerance.

Changes that Would Increase Your Expected Return

There are, however, some steps that aggressive investors can take that actually would increase their expected returns.

[Please understand that I'm not encouraging you to increase the level of risk in your portfolio. I'm just saying that if you were interested in doing so, there are better ways to go about it than investing in high-cost actively managed mutual funds.]

If you want to increase your portfolio’s risk and expected return, just change your asset allocation accordingly: Increase your allocation to stocks or shift your stock allocation toward particularly high-risk categories of stocks (i.e., small-cap stocks, value stocks, or emerging market stocks).

For example, the following simple portfolio would be extremely aggressive, while still having an average expense ratio of just 0.25%:

• 50% Vanguard Small-Cap Value ETF,
• 25% Vanguard FTSE All-World ex-US Small-Cap ETF, and
• 25% Vanguard MSCI Emerging Markets ETF.

In short: The fact that an investor a) wants high returns and b) is willing to take on a lot of risk in the hope of achieving those returns does not suddenly make it necessary or wise to pay exorbitant costs to fund companies and/or brokerage firms.

May 16, 2011 3 comments

In the last few months I’ve received numerous questions about what to do with your portfolio if you expect inflation to shoot upward in the near to intermediate future.

Is High Inflation in Our Future?

Despite all the press inflation has received recently, the market’s expectation for inflation appears to be rather modest.

The difference between yields on TIPS and nominal Treasury bonds of a given maturity is a good estimate of the market’s expectation for inflation over that period. Based on current yields of nominals and TIPS maturing in early 2021, the market appears to expect inflation of approximately 2.6% per year over the next decade. Not zero, but not exactly off the charts either.

But What if the Market is Wrong?

Of course, it’s always possible that the market will turn out to be wrong. Inflation could end up being significantly higher or lower than the market’s prediction.

Whether or not it makes sense for you to do anything to prepare for a high-inflation scenario depends on how exposed you are to inflation risk:

• If you’re entirely dependent upon your investments for income, you’re more exposed to inflation risk than somebody who is still working (or who could easily go back to work).
• If you rent, you’re more exposed to inflation risk than somebody who owns his/her home.
• If a significant amount of your retirement income is made up of a pension (or income annuity) without inflation adjustments, you’re more exposed to inflation risk.

If you find that you’re exposed to a great deal of inflation risk and you want to do something to protect yourself, any of the following might be prudent:

• Shorten the maturity on your nominal bond holdings. If inflation spikes upward, short-term bonds would be less affected than long-term bonds.
• Move more of your bond holdings into TIPS.
• Don’t prepay your mortgage. Having a low, fixed-rate mortgage during a period of high inflation would mean that you’re borrowing money at a very low–or even negative–after-inflation interest rate.
• Consider allocating a small portion of your portfolio to commodities. (Per Larry Swedroe’s excellent Guide to Alternative Investments, collateralized commodity futures–CCFs–would be my preferred means of achieving a commodity allocation, were I to desire one.)

Three Final Thoughts

If somebody tries to tell you that TIPS offer little protection against inflation because the government’s measure of inflation does not include food or energy, do not listen. While the “core inflation” figure published by the Bureau of Labor Statistics does indeed exclude food and energy prices, CPI-U (the figure upon which TIPS adjustments are based) does include both food and energy.

While stocks can be expected to outpace inflation over the long haul, they are not a very good hedge against sudden unexpected inflation, because you cannot count on them to conveniently shoot upward in price when inflation strikes.

If I had to place a bet on either the market’s expectation (modest inflation) or the mainstream financial media’s expectation (high inflation), I think you know where my money would be. The market isn’t always right, but I don’t often like to bet against it.

April 18, 2011 9 comments

When it comes to evaluating investment advice, it pays to be a bit cynical. Asking yourself how the person giving the advice gets paid is always enlightening.

Naturally, this applies to financial advisors. For example:

• Commission-paid advisors recommend investments that pay commissions (e.g., actively managed mutual funds and insurance products).
• Advisors who charge based on the size of your account have an interest in convincing you not to use other financial products such as annuities.

But it applies to other sources of investment information as well.

Mainstream Media

If you’re watching a personal finance program on TV, it can be helpful to look at the program’s major sponsors/advertisers.

Is the program sponsored by actively managed fund companies or by discount brokerage firms that make money when you rapidly buy and sell individual stocks? If so, you can see why the program might want to avoid stepping on their sponsors’ toes by saying that buying and holding low-cost index funds is the best way to invest.

Or for smaller, local programs: What do the hosts do for a living? In a recent discussion at the Bogleheads forum, an investor asked why one of the hosts of a local radio program was insistent on her recommendation of actively managed mutual funds rather than index funds.

A little research turned up the fact that the host is a commission-paid financial advisor. Mystery solved. Low-cost index funds don’t pay commissions. Expensive actively managed mutual funds do.

Academic-Looking Research

Even seemingly-unbiased studies can be affected by conflicts of interest. It’s important to find out who did the research. For example, was it performed by:

• The Chief Investment Officer of an actively managed fund company?
• Executives at a brokerage firm?
• The trade organization of mutual fund companies (the Investment Company Institute)?

Any of those scenarios would give you a hint as to why the research draws the conclusions it does.

And just as important: Who funded the research? Was the study performed by professors, but paid for by insurance companies? That might give you a clue about why it says such good things about variable annuities or whole life insurance.

Bloggers

Finally — lest you think that I’m suggesting that blogs are a source of perfectly-unbiased information — let me point out that bloggers have conflicts of interest too.

We make money recommending companies that have affiliate programs. For example, I earn a commission if you open an account at Scottrade through one of my links. I earn nothing if you open an account at Vanguard. For the same reason, it’s more profitable for me to recommend Ally Bank than Bank of America.

Follow the Money

Before making any major decisions based on financial advice, always ask: Who is this advice coming from, and how is this person paid?  You may find that it’s worth getting a second (differently biased) opinion.

November 24, 2010 6 comments