By far the greatest source of personal consternation as a professional in markets, is an investors’ obsession with finding the best stocks, or the best stock pickers. The fact that investors pursue this objective at all undermines all meaningful arguments about efficient markets.
After all, why on earth would the well informed, rational actors that constitute efficient markets spend all their time on the component of the investment process that is likely to make the least amount of difference to their long-term wealth?
Because a few proactive tweaks are all it takes for any individual to outperform the “market” as a whole over time. Even within the relatively short-term time horizon of 1-6 months I myself like to take a balanced approach.
That means not only holding a combination bullish, bearish and market neutral positions, but also structuring trades that are down for both a net debit and net credit of premium.
Meaning, I want to make sure that I’m negatively impacted by a sharp move up or down, but also not that I’m not dragged down by time decay. Remember, options are an eroding asset. And while it’s attractive to sell something that might ultimately be worthless, there is plenty of money to be made by buying these contracts on the cheap.
For most investors allocation is a means of diversification across various asset classes such as stocks, bonds, commodities and real estate. The strategy is based on the principle that different assets perform differently in different market and economic conditions.
Hence diversification reduces the overall risk in terms of the variability of returns for a given level of the expected return. Asset diversification has been described as the only “free lunch” you will find in the investment game.
Although risk is reduced, as long as correlations are not perfect, it is typically forecast (wholly or in part) based on statistical relationships that existed over some past period.
Expectations for return are often derived in the same way. But note, predicting future risks and returns based on history means there is no guarantee that past relationships will continue in the future. This is one of the “weak links” in traditional asset allocation and during unusual periods such as the financial crisis, it did little to protect portfolio’s as nearly all assets classes declined for nearly a year. But in the big picture that proved to a blip in time.
The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
- Time Horizon: is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
- Risk tolerance: is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment. In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.”
There are basically three different ways you can rebalance your portfolio:
- You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
- You can purchase new investments for under-weighted asset categories.
- If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you go with will trigger transaction fees or tax consequences. Your financial professional or tax adviser can help you identify ways that you can minimize these potential costs.
Bottom line: Asset allocation is the best way to produce consistent returns over the long haul.
Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.