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Modern Portfolio Theory (MPT)- How Financial Advisors Invest Your Money

Mastering covered call writing has taught many of us how to self-invest. In the past, we depended on financial managers to handle our hard-earned money. In the hands of the right person this is not an inappropriate path to take for some of us. Certain investors both self-invest and hire a financial advisor. Did you ever wonder how these money managers determine how to invest in our portfolio? It all starts with a meeting of all involved parties.

You (and your spouse) nervously enter the office of your investment advisor representative with a boatload of papers and a myriad of questions. One of those questions may be, “What questions should I ask?” You sit down and then you are offered a cup of bitter coffee. Your mouth is feeling fine but somehow you feel like you’re about to have a root canal! After pleasantries are exchanged, you fill out numerous forms and surveys. Questions are asked and answered, some of which seem more psychological than financial in nature. An appointment is made for a follow-up consultation.

You return a week later and a folder is handed to you with a roadmap as to how to handle your financial future. All the information from the previous week was fed into a computer and these are the results. Well, how did that happen and why? Were names of investment securities picked out of a hat, or was there sound rationale behind this process? Enter the Modern Portfolio Theory.

In simplistic terms, this theory assumes that investors want the highest returns for the least amount of risk.  As opposed to the older Prudent Man Rule, which stated that a properly constructed portfolio should have no risk (hello T-bills), the MPT assumes that risk cannot be totally avoided, but rather, can be appropriately managed. In MPT, the portfolio in its entirety (not the individual securities within the portfolio) is evaluated. More specifically, the MPT states that holding options in an account is acceptable as long as the risk is counterbalanced by other entities within that portfolio. A risk-free portfolio will be overcome by inflation.

            Three Basic Concepts of the MPT 

Expected Return:

Expected return is the possible return from a portfolio under different market conditions (bullish, bearish and neutral), weighted by the likelihood that the return will occur. For example, if Portfolios A and B both have expected returns of 6%, but Portfolio A has a range of expected returns from (-)10% to +25% in different market conditions, while B has a range between 1% and 15%, wouldn’t you sleep better at night with plan B? B would be considered a more optimal plan because you are getting the same return for less risk.

Standard Deviation:

This is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. MPT prefers stocks and portfolios with low standard deviations. Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.

  • Around 68% of data are within one standard deviation of the mean
  • Around 95% of data are within two standard deviations of the mean
  • Around 99% of data are within three standard deviations of the mean

Here is how a chart of standard deviation is described:

Modern Portfolio Theory

Standard deviation

Correlation:

This measures the degree to which investments are related. Assets showing a low degree of correlation produce the best long-term results. This has everything to do with proper diversification. Correlation is quantified as follows:

  • 1.0 = Perfect correlation. Returns move in the same direction at the same time.
  • 0 = Uncorrelated. No correlation between the returns of two securities
  • -1.0 = Perfect negative correlation. Returns move in opposite directions at the same time.

Most investment advisors prefer a portfolio with a slightly negative correlation.

Constructing Optimal Portfolios:

According to the MPT, there is a series of possible portfolio mixes that are optimal, that is, they have the greatest returns for a given amount of risk. These portfolios are diversified into several asset classes including stocks, bonds and cash equivalents. When fed into the computer a graph of these optimal portfolios is produced and referred to as the Efficient Frontier. This is an asset pricing model that describes the relationship between expected risk and expected return for a portfolio. Let’s look at such a graph below:

Modern Portfolio Theory

The Efficient Frontier

As you can see, the lower the volatility (risk, horizontal line), the lower the returns (vertical line). Based on the information you gave to your investment advisor, an appropriate portfolio can be selected for you that falls on the efficient frontier (curved line). If a portfolio falls to the right or under of the EF, it is not an optimal portfolio because it would have the same expected return with a higher anticipated volatility.

The mathematics is not important. However, the concept behind this MPT is. Finding a portfolio that is right for you involves locating the proper mix of securities that will give you the best chance to achieve the highest returns for the risk tolerance that meets your comfort level. Covered call writing should represent only part of our total portfolio. As I have memorialized in my books and DVDs, I have a significant portion of my total portfolio in real estate, cash-equivalents and bonds. My favorite investment strategy, by far, IS covered call writing.  There you have it….just like most root canals….painless!

Upcoming Live Events:

  • November 10th: AAII Chicago Chapter:
  •                http://www.aaii.com/chapters/meeting?mtg=2227&ChapterID=1
  • January 19, 2013: AAII Milwaukee Chapter
  • February, 2013: The Money Show’s Stock Traders Expo @ The Marriott Marquis Hotel, NYC
  • April 20, 2013: Atlanta Options Investor Club
  • May 14, 2013: Long Island Stock Traders Meetup
  • September 17, 2013: AAII Philadelphia Chapter

Market tone:

Mixed reports this week continue to support the feeling that the labor market is far from where we need it to be as stated by Fed Chairman Ben Bernanke:

  • The trade balance widened by 4.1% to $44.2 billion, the largest gap since May
  • Capital goods exports increased indicating that businesses are preparing to expand production
  • According to the Federal Reserve’s September Beige book, 10 of 12 districts expanded “modestly”
  • Producer prices were up 1.1% in September, above the 0.7% expected
  • Core producer inflation was unchanged for the first time since October, 2011
  • Jobless claims came in @ 339,000 below the 370,00 expected

For the week, the S&P 500declined by 2.2%, for a year-to-date return of 15.5%, including dividends.

Summary:

IBD: Market in correction

BCI: Neutral outlook favoring in-the-money strikes, 3 to 2. Global, political concerns as well having less confidence in the upcoming earnings season is resulting in a more cautious approach to this site’s investment decisions.

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About Alan Ellman

Alan Ellman loves options trading so much he has written three top selling books on the topic of selling covered calls alone. He is a recently retired dentist, a personal trainer, successful real estate investor, but he is known mostly for his profound stock option strategies.

12 Responses to “Modern Portfolio Theory (MPT)- How Financial Advisors Invest Your Money”

  1. Alan Ellman October 13, 2012 3:10 pm #

    Offsite Q&A:

    Alan,

    Thanks for the valuable information.

    I hope you don’t mind but I want to run something buy you to make sure I am not missing anything.

    MLNX is on your approved list
    MLNX closed yesterday at 103.38/share
    October 20 Strike of 105 ended at 8.00

    So in theory I could buy 100 shares at $103.38+ ($10,338)
    Sell an option at 8.00+/- ($800)

    And by this coming Friday if the stock rises to above $105.00 and I let the option get exercised I would net $9.62+/- per share or 9.3% for 5 days, or if the stock declines I am essentially protected down to $95.38. Of course if the stock rises to above $105 by Friday mid-day all of the time value disappears and I can buy back the option for just the intrinsic value and sell the November strike. What am I missing here except an incredible opportunity? It almost sounds too good to be true.

    My response:

    I am SO glad you sent in this question. My response will save (and make for you) a lot of money. In this example, you are selling an out-of-the-money call option which consists of time value only. Time value consists of time to expiration + the implied volatility of the stock. Now there is only 1 week remaining until the October contracts expire so there is virtually no premium related to time. It’s all implied volatility. Next, we are generating an 8% return in one week. It seems too good to be true and when something seems too good to be true, it usually is. One of the first things we think of when there is such an outrageous premium return is an upcoming earnings report. Take a look at the premium report and you will find MLNX in the “gold cells” of the “running list” That means the stock has passed all screens but has an upcoming ER (October 17th) so is NOT eligible until after the report. I have created a chart showing the price response to the last two ERs for this equity. HUGE price movements that can go in either direction. Way too much risk for us. We can receive an $8 premium and lose $25 in share depreciation. Avoiding ERs is one of the prime rules of the BCI methodology and that’s why we highlight these securities in the gold cells. Watch the premium return drop after the report. See the chart below (Click on image to enlarge and use the back arrow to return to this blog).

    Alan

  2. Barry B October 13, 2012 4:50 pm #

    Premium Members,

    The Weekly Report for 10-12-12 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

    Note: A REVISED VERSION OF THIS WEEK’S REPORT WILL BE SENT OUT SHORTLY

  3. Barry B October 13, 2012 7:37 pm #

    Premium Members,

    The Weekly Report for 10-12-12 has been revised and uploaded to the Premium Member website and is available for download. There was a data issue that has been resolved. Look for the report dated 10-12-12 RevA.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  4. Barry B October 13, 2012 7:45 pm #

    Blue Collar Investors,

    As you know, we are entering “earnings Season”. To help you select stocks and ETFs during this time in the trading calendar, please read Alan’s article, “Constructing your covered call portfolio during earnings season”.

    The article can be viewed using the following link:
    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,

    Barry and The BCI Team

  5. Dave October 14, 2012 8:13 am #

    Alan,

    Do you invest in a cash or margin account? For IRAs, traditional or Roth?

    Thanks.

    Dave

    • Alan Ellman October 14, 2012 12:42 pm #

      Dave,

      As far as cash vs. margin, this will depend to a great extent on your personal risk-tolerance. My feeling is that cash accounts are more appropriate for most retail investors. In margin accounts, the broker will lend up to 50% of the stock price or strike price whichever is less. You are leveraging your trades which can be very good or magnified negatively if the trades turn against you. You are also paying interest to your broker.

      Roth IRA vs. Traditional: Best answered by your financial advisor who knows your specific information.

      Alan

  6. Fran October 14, 2012 2:38 pm #

    Alan,

    If a stock has a dividend is the call premium affected either way? Thanks as always.

    Fran

    • Alan Ellman October 15, 2012 4:25 pm #

      Fran,

      Since the share holder, not the option holder, receives the dividend distribution, the call premium is less valuable than for an equity without a dividend distribution, all other paramaters being equal.

      Alan

  7. Alan Ellman October 15, 2012 4:27 pm #

    Oilprice.com:

    I have accepted an invitation to write periodic articles for this OIL&Gas website. Here is a link to my first article published today:

    http://oilprice.com/Finance/investing-and-trading-reports/Using-Oil-Gas-Securities-Plus-Stock-Options-to-Generate-Monthly-Cash-Flow.html

    Alan

  8. Alan Ellman October 16, 2012 8:13 am #

    Running list stocks in the news: BCOR:

    Blucora Inc. (formerly Infospace Inc.), a maker of tax preparation software reported its 3rd consecutive positive earnings surprise on July 26th beating consensus estimates by 240%. Earnings were up 200% and revenues rose by 85.8%. The company gave positive guidance for the upcoming November 7th ER. Consensus estimates for 2012 is for growth of 65.6% and for 2013, 35.4%. BCOR trades at a PEG of 1.1 more favorable than its industry average of 1.5. Our premium running list shows an industry rank of “A” and a beta of 1.36.

    Alan

  9. Joe October 16, 2012 4:48 pm #

    Alan, It may work out – but it may not. Just want to get your thoughts. I purchased and sold a covered call on MLNX based upon the 9/21 report that reflected an ER date of 10/24 – so I thought I was safe. I guess I should have checked with Whisper to see that the ER date was confirmed – because within this period, the ER date was announced as 10/17 – so I’m stuck. In the future, what should I do if an earnings date surprisingly pops up in the period. Thanks. Joe

    • Alan Ellman October 16, 2012 5:21 pm #

      Joe,

      MLNX is due to report after market close tomorrow. When a report is moved up and I’ve already taken a position, I will close my short position and either hold or sell the underlying depending on the confidence I have in the ER. If you look at the premium credit and the premium debit to close as well as the entry and possible exit price for the equity, the deal may turn out to be profitable despite the surprise. For example, if the option was sold for $3 and due to time value erosion can be bought back for $2 and the share price is the same, you’ve made some money.

      Alan

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