Lessons From the Bear Market

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  1

  MarkWolfinger

  11/09/09 | Report as spam

  RE: Lessons From the Bear Market

  Agree completely.
  
  Too many investors over-estimate how well their portfolios perform.
  
  The last bear market demonstrated how asset allocation just couldn't keep up when all markets (bonds were the exception this time) fell in tandem.
  
  The inquiring mind looks for better approaches and does not believe that 'head in the sand' is going to work.
  
  Peter Lynch or no Peter Lynch, an investor can GUARANTEE that the value of a portfolio cannot fall more than a predetermined amount - equivalent to the deductible on an insurance policy.
  
  You decided that options are not for you, but they are the best risk-reducing tool available anywhere. Guaranteed to work.
  
  And the cost: The cost is limiting the upside. We have very few raging bull markets and sacrificing the huge potential gains is a solid, conservative idea for many. Not for everyone, but for millions of investors.
  
  We've already agreed to disagree on this - but your readers deserve better.
  
  Mark
  
  
  

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  2

  larry swedroe

  11/09/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  what you should say is that IN YOUR OPINION they are the best tool. IMO they are not, as I explained in my book. IMO there are superior alternatives

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  3

  jon 2020

  11/09/09 | Report as spam

  RE: Lessons From the Bear Market

  Larry,
  
  In your book, you discussed covered calls. But there wasn't discussion about alternative strategies to control risk such as cutting off left tail risk by buying puts. Or other strategies such as mechanical market timing based on 200-day moving average (which has a great track record across multiple markets and very long time period e.g. M. Faber's paper).
  
  I personally don't subscribe to these alternative strategies as I don't think I have the stomach to see them through (tracking risk), but I'd be very interested in any opinions you have.
  

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  4

  jon 2020

  11/09/09 | Report as spam

  RE: Lessons From the Bear Market

  btw by 200-day moving average I meant the idea of selling when the market is below the average, which historically has reduced left tail risk of deep bear markets.
  
  

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  5

  ajwillms

  11/09/09 | Report as spam

  RE: Lessons From the Bear Market

  While cash covered calls, puts, and collars can all lessen risk to the downside, they also carry costs (either out of pocket costs, opportunity costs, or both). There is no free lunch in an efficient market.
  
  If an investor is willing to pay those costs for the "portfolio insurance" options can provide, then the key is to use them in a passive way. In other words, the options have to be used uniformly, or you may While cash covered calls, puts, and collars can all lessen risk to the downside, they also carry costs (either out of pocket costs, opportunity costs, or both). There is no free lunch in an efficient market.
  
  If an investor is willing to pay those costs for the "portfolio insurance" options can provide, then the key is to use them in a passive way. In other words, the options have to be used uniformly, or you may inadvertantly inject market timing and stock selection into your portfolio managemnt.
  
  Unfortunately, using options as part of a passive investment strategy isn't easy, because of different expiration dates, implied volatility and the like. The tricky part is to develop rules that you abide by irrespective of current market conditions (much like sticking with target model allocations). inject market timing and stock selection into the portfolio.
  
  Unfortunately, using options as part of a passive investment strategy isn't easy, because of different expiration dates, implied volatility and the like. The tricky part is to develop rules that you abide by irrespective of current market conditions (much like sticking with target model allocations).
  
  

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  6

  larry swedroe

  11/11/09 | Report as spam

  RE: Lessons From the Bear Market

  The way to cut the tail risks without reducing expected returns and earning the returns in tax efficient way is to
  A) lower your exposure to beta
  and
  B) increase your exposure to size and value risk factors.
  
  Think of it this way. Say you have a portfolio that is 100% stocks and invested in TSM. Say returns expected 10% (historical figure, not my expectation). But small value stocks have returned say 14%. So need lot less exposure to beta (equity allocation) to get same 10% return. For simplicity sake assume bonds expected return 6%. So could now be 50/50, but all equity in SV, and have same expected return. But clearly downside risk is much less (as is upside). but you don't create the negative skewness that covered calls do. And returns are earned tax efficiently.
  
  I hope that is helpful
  
  Larry

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  7

  MrRosemary

  11/11/09 | Report as spam

  RE: Lessons From the Bear Market

  And your plan is a lot easier than fiddling with options all the time.

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  8

  mid-coast Mainer

  11/13/09 | Report as spam

  RE: Lessons From the Bear Market

  Would you ever suggest someone have all their equity in
  SV (which I assume means small value)? What if someone
  is overweighted in SV and then the market shifts and large
  cap growth is doing best? Would you call shifting your
  equity positions to LCG "market timing"?

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  9

  MarkWolfinger

  11/13/09 | Report as spam

  RE: Lessons From the Bear Market

  Say what you like, but the evidence is real: BXM (CBOE Covered Call Index) shows that writing one month, at the money, covered calls, has outperfromed SPTR - the S&P 500 total return index since incepetion. That's more than 21 years ago.
  
  And the biggest key, is that it has done it with reduced volatility. Less volatile returns is a big deal and investors seek it. It's available, but too many advisors are blind to the benefits of this, or any, option strategy. I don't understand why they feel threatened.
  
  Larry, you correctly point out the negatives of investing this way, buy the positives are not taken as seriously as they outght to be. The track record is impressive.
  
  
  
  

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  10

  larry swedroe

  11/14/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  
  First, the record you state does not include (I believe) the impact of taxes--and if investors have the ability to choose locations between taxable and tax advantaged accounts they should hold the equities in taxable accounts. The literature is quite clear on that, and it doesn't even account for all the benefits of doing so. Covered call writing is less tax efficient.
  
  Second, the alternative you suggest is only one strategy to reduce risk, and as I have pointed out there is a FAR superior alternative which is also more tax efficient and doesn't create the negative skewness that covered call writing does. In fact, it significantly reduces the risk of fat tails, the very risk you are trying to reduce. The superior alternative is to tilt the portfolio to small and value and reduce beta.

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  11

  ajwillms

  11/14/09 | Report as spam

  RE: Lessons From the Bear Market

  Larry,
  
  Seems to me you are advising about reducing risks through asset allocations, which I strongly agree with. But options can hedge risk, which I believe is different . In my opinion, asset allocation and hedging has advantageous in some market conditions than asset allocation alone. While tax efficiency needs to be considered when evaluating the relevant merits of each approach, investors have had an excellent opportunity to harvest losses over the last 12 -18 months. Those who did can use their loss carry forwards to offset gains that would be triggered by a use of options to hedge against a market decline.
  
  At least that?s how I see it.
  
  AJW

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  12

  MarkWolfinger

  11/14/09 | Report as spam

  RE: Lessons From the Bear Market

  I truly don't see the tax efficiency problem. If you use index options, all gains become 60% long term and 40% short term. That's a good deal.
  
  As you stated before, we will agree to disagree, but I find your suggestion to be FAR inferior, not superior.
  
  The buy, hold, diversify and rebalance crowd is simply behind the times. Hedging risk is guaranteed to provide protection. That's better that sticking with methods that are showing signs of not working out as well as expected (a la 2008) - when markets tumble.
  
  For the record, covered call writing is just an example, of how options can be used to boost returns, reduce volatility, and provide some downside protection. Far more efficiently than any re-balance method can.
  
  And there are better option methods than writing covered calls.
  
  I think I'll abandon this thread and return your blog to you.
  
  Thanks for the conversation.
  
  Mark
  http://blog.mdwoptions.com
  
  
  
  

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  13

  larry swedroe

  11/15/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  60% Long Term and 40% short term is NOT a good deal. Also I don't know how you can make the statement about my approach--as the data is clear, as I will present for you.
  
  As to taxes, If you own a total market fund, ETF or tax managed fund almost all the gains are long term and that makes a very large difference in AT returns vs a strategy with 40% ST gains.
  
  
  Here are two portfolios for the period 1970-2008.
  
  The first is 100% S&P 500, annualized return 9.5% and SD of 18.2%. Now let's even assume (I don't know) that a call writing strategy might (pretax) improve slightly on it.
  
  The second portfolio is just 32% small value stocks and 68% one-year Treasuries. That portfolio had a return of 9.6% and an SD of just 9.3%. Same return with half the SD. In addition the first portfolio had a year with a 37% loss (call writing would only reduce that somewhat) while the second portfolio had a worst case of just 11%. And of course the gains would be earned in a more tax efficient way.
  
  Now add in some international diversification and the portfolio becomes even more efficient due to diversification benefits.

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  14

  larry swedroe

  11/15/09 | Report as spam

  RE: Lessons From the Bear Market

  AJW
  Yes options can be used to hedge some risks, which I have pointed out. And if that is the purpose use them for that purpose (insurance) and are willing to pay the premiums, then they make sense.
  
  And of course, as you note, and I have stated many times, buy and hold is not sufficient--you need to buy, hold, rebalance and tax manage your portfolio on a year round basis.

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  15

  MarkWolfinger

  11/15/09 | Report as spam

  RE: Lessons From the Bear Market

  Larry,
  
  I guess the conversation is endless.
  
  You only get the 100% LT treatmnt when you hold for more than one year. I suppse that's okay for a true believer in buy and hold/rebalance.
  
  Option strategies are designed to be more flexible and trades are held much less than one year.
  
  Once again I am outside the current mainstream, but I believe that anyone who makes a trade decision based on taxes is making a huge mistake.
  
  If it's time to rebalance or exit a trade for any reason, holding it longer for a tax benefitis just wrong. Penny wise, ton foolish.

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  16

  larry swedroe

  11/15/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  You are outside the mainstream because the only kind of returns that matter in taxable accounts are AT returns. You cannot spend pretax returns. And options strategies are not tax efficient, easily can cost several percent a year in returns.
  
  Also TM funds and ETFs are highly tax efficient, generally eliminating or at least minimizing the realization of ST gains, which is where most of the benefits of tax management come from. That is what the evidence from academic research shows. TAXES do matter--they should not be only factor, but they are an important one.
  
  And your comment about rebalancing and tax management, the research shows it is better to wait for long term gains than to rebalance--avoiding the ST gains which are taxed at much higher rates (now if ST gain is small might want to take it--which is why rebalancing is an art). This is in fact the strategy DFA uses in its TM funds--don't intentionally realize ST gains.

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  17

  MarkWolfinger

  11/15/09 | Report as spam

  RE: Lessons From the Bear Market

  Intentionally refusng to realize short term gains - coupled with not hedging your cliets portfolios leaves you well paced to have zero retuns.
  
  And I'll bet you love the tax consuences of that.
  
  My goal is to make money, pay taxes, and be happy.
  
  I just don't undestand why the financial advisor indutry is able to sell its early 20th century theories to the investing public.
  
  I think Willim Berntein said it best:
  
  "If rigorous precautions are not taken, the financial services industry will strip investors of their wealth faster than they can say ?Bernie Madoff ?The average stock broker services his clients in the same way that Baby Face Nelson serviced banks "
  
  
  
  

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  18

  formerlythere

  11/16/09 | Report as spam

  RE: Lessons From the Bear Market

  Two thoughts:
  
  Mark, you sound like the kind of pitchman that gets all kinds of investors into trouble. I'm aware of numerous investors who were burned by options bettors such as yourself in this bear market. The lawsuits said investors filed against the call players they were using suggests they see nothing "superior" about that strategy in hindsight.
  
  Second: Larry, I love the line that "Bear markets can turn investors with 30-year horizons into investors with 30-day horizons." Sad but true. And now many of those investors who retreated to cash continue to sit on the sidelines while those who stayed the course (or even better, rebalanced as appropriate) are nearly back or are back to where they were when Lehman Brothers was still in business.

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  19

  larry swedroe

  11/16/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  
  IMO, you are like the hedgehog who has one great idea about how the world works. And you view the world through only that one lens-hedging using options. Unfortunately, that causes you to fail to recognize that there are other ways to think about things and ways that produce more efficient results.
  
  You seek to reduce risk by using options, but that is only one way to do it. The evidence, as I presented, is that there are more effective ways to do so. Not only more effective in terms of changing the potential dispersion of returns in a more favorable way than the use of option strategies, but also more tax efficient.
  
  Option strategies are tax inefficient and it is somewhat amusing that it is only those that use tax efficient strategies state that investors should ignore taxes---when it is only AT returns that you can spend. Here is good example.
  
  Let's assume that you have a fund that is 90% tax efficient, producing a 10% PT return and a 9% AT return. Let's assume that this is your option strategy (though it almost certainly is not close to 90% tax efficient) You have fund B, which focuses on tax management produces a 9.5% PT return and a 9.25% AT return. Now in a tax-advantaged account Strategy A is better, but in a taxable account strategy B is better. Taxes matter.
  
  Another point is that many investors fail to understand that the goal of tax managed funds is NOT to MINIMIZE taxes. Instead it is to produce the highest AT returns. So in the above example, Fund B paid just 0.25 percent in taxes. But now you have Fund C which is also tax managed but uses a different strategy, not focusing on minimizing taxes, but on maximizing AT returns. It earns PT 9.9% and pays out 0.5% in taxes, producing 9.4% AT returns. It is less tax efficient than B, but it is the fund you should want to own.
  
  Let's assume that you have a fund that is 90% tax efficient, producing a 10% PT return and a 9% AT return. You have fund B, which focuses on tax management produces.
  
  So I showed you how you could dramatically improve the/reward ratio of investing in equities and how to do so in a tax efficient way. The strategy of adding size and value exposure while lowering equity exposure dramatically lowered the maximum losses in any period in a far better way than covered call strategies could have done, and did so in a more tax efficient manner. Covered calls have the flaws of both being tax inefficient and also changing the potential dispersion of returns in a very negative way--they create negative skewness and leaves you with excess kurtosis--both characteristics investors don't like. And note that the way they change the distribution of returns renders meaningless the use of Sharpe ratios--and despite that those marketing such strategies show Sharpe ratios as a justification for the strategy (despite knowing it is no longer a meaningful measure because returns are no longer log normally distributed). That is why I placed them in the flawed category--there simply are better ways to approach the problem. If they were the best I would use them. I have no reason not to.
  
  The bottom line is that investors can manage risks quite well through the AA process without using options which are tax inefficient and change the dispersion of returns in negative ways and have costs.
  
  

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  20

  MarkWolfinger

  11/17/09 | Report as spam

  RE: Lessons From the Bear Market

  Larry
  
  1) I am not an 'options bettor.' I use options ONLY to reduce risk.
  
  As someone who prefers to blindly follow outdated methods, you simply don't undertand.
  
  2) I'm sure plenty of people were burned in the bear market, but you are accusing the wrong person. I 'pitch' nothing. You are referring to Optionetics and others of their ilk.
  
  3) I teach. I educate. I do not make recommendations. I not tell people what do with their money.
  
  4) I don't suggest the types of strategies that brought on these lawsuits.
  
  5) Staying the course worked this time, but I never suggested anyone exit the market. That's Cramer and his kind. Anyone who followed by teachings had collars in place and suffered minor losses compared with those who depended on 'asset allocation'to protect them.
  
  6) I get it. I point out the problems with most financial planners and you attack.
  
  7) 'More efficient'? Sez you. Your results are far less efficient. Plus,when I ask if you devise plans for customers by having computer spit out pretty graphs, you ignre question.
  
  Do you use YOUR brain to devise plans, or computer brain?
  
  8) Yes, more tax efficient - but only if any profits remain when it's time to exit a position. This another old wive's tail you use to collect fees.
  
  9) Covered call writing is not near to of my list of preferred methods. Jus mentioned it becasue it was appropriate to dcussion.
  
  10) I see you are too angry to continue discussion.I removed alerts, so eill not see your reply.
  
  11) OK. Endof discusion for now. If we have another big bear, I'll return to see if you survived.
  
  I wish your clients well.
  
  

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  21

  formerlythere

  11/17/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark, you crack me up. You accuse. You taunt. You boast. But when it gets thrown back in your face, you cower like a coward. (And for the record, only half of what you cited as Larry's retorts actually came from Larry; the other half came from me. Proper attribution is another point to consider when it comes to avoiding lawsuits.)
  
  For disclosure's sake, I am a passive investor from the same camp as Larry. Our firm manages around 60 clients, and yes, Mark, as hard as it may be for you to grasp, a vast majority of them are happy following (or perhaps still amidst) this bear market. Why? Because they followed academically-based investment theory, stuck to that strategy even in tough times, and are now reaping the rewards.
  
  Did a computer tell me, or my clients, how they should invest? No. Academic research did. This is the gist that you fail to grasp. To call Modern Portfolio Theory and asset allocation outdated -- particularly at a time when they are showing how valuable they are -- just exposes your personal bias.
  
  Which is fine. Every man is entitled to his bias. That's your decision and I do not chide you for sticking to your guns. Personally, I'm more offended by your spelling and your grammar than your investment philosophy.

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  22

  larry swedroe

  11/17/09 | Report as spam

  RE: Lessons From the Bear Market

  Mark
  
  Interesting comments.
  To keep it simple, I presented you with data showing how one could have produced a more efficient portfolio than investing in the S&P, far more efficient. You make the claim that you have strategy that is even more efficient. I asked you to provide the data to show it--and you did not. The opportunity is still there for you to do so, instead of making claims, produce the data.
  
  As to your question about computers generating the answers, I did not respond directly because if you have been reading any of the blog posts and/or my books you would know that I don't do that, nor do I believe that to be a good approach and I have written on why models like efficient frontier models can be very dangerous. When you make accusations you should at least have good reason for making them
  
  Why you would think I am angry I have no idea. You made statements and I took the time to respond addressing all of your points. But when someone disagrees with you all you seem to say is they are wrong.
  
  As to this comment: "This another old wife's tail you use to collect fees." No, my comments on taxes are based on the academic research, not some wife's tale or my opinions. That is true of the strategies I recommend, not just related to taxes.
  
  Finally, I will add this, the research shows that a difference between hedgehogs and foxes is that not only are hedgehogs wrong more frequently in their forecasts but they are also more confident they are right.
  
  See you after the next bear market

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  23

  Grand_Supercycle

  11/18/09 | Report as spam

  RE: Lessons From the Bear Market

  More people should study trends !
  
  I use technical analysis to identify trends which can also tell us where the economy is headed.
  
  My long term USD indicator has been giving BULLISH warnings for some time and I am expecting a USD rally.
  
  My indicators can identify trend changes before they occur.
  
  They warned me of an impending market crash back in early *2007*
  
  The VIX index continues to give bullish warnings as well.
  
  Is the bear market rally ending ?
  
  I post my analysis at this forum:
  http://www.zerohedge.com/forum/market-outlook-0