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 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.
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:
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:
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:
- 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
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.
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 ([email protected])