Today we'll continue our discussion on the shutdown by exploring further the emotions financial crises cause and the risky behavior that can be generated as a result.
One of the reasons investors resort to risky behavior is because they either don't have investment plans they can stick to, or if they have plans they don't have the discipline to adhere to them. As Warren Buffett has noted, a main cause of the failure to earn market returns is "a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline)."
Take a step back now and think what would have happened if each of the 17 prior times the government shut down you bailed out of the market, incurring trading costs and, in taxable accounts, capital gains taxes. Do you think you would have benefited? How would you have known when to get back in?
There is never a safe time to invest. If you think otherwise, consider the following. The economy has performed poorly since the market bottomed out in March of 2009. It's been the worst recovery in post-war history. And we've had many crises since then to deal with. There was never a single day since then when investors could possibly have thought it safe to invest. In fact, PIMCO's Mohammed El Erian and Bill Gross predicted years, if not decades, of a poor economy and low stock returns. Yet the S&P 500 has increased from a low of 666 to about 1,700 in that time frame.
If you go to cash because of concerns over the economy, you are virtually doomed to fail because you'll never see a green light letting you know it's now safe to invest again. And if you think you see a green light, it's probably well after a period of strong returns (and you've missed the rally).
There's an overwhelming body of evidence against the ability of investors to successfully time the market -- which is why in his 1996 letter to shareholders, Buffett said, "We continue to make more money when snoring than when active." He also added this advice: "Inactivity strikes us as intelligent behavior."
As explained in my book, "Think, Act, and Invest Like Buffett," one of the greatest ironies, and tragedies, is that while Buffett is idolized by millions of investors, they not only ignore his investment advice, but also tend to do exactly the opposite of what he advises. With that in mind, let's go over the right way to think about the current situation.
There will be crises
First, and most important, as mentioned above your investment plan must incorporate the fact that financial crises are going to occur and that you're going to have to live through them with equanimity. The only way I know how to do that successfully is to not only have anticipated the crisis, but also to have made sure that you didn't take more risk than you had the ability, willingness and need to take. So make sure your plan is the right one for you.
No one can predict the good or bad
Second, it's critical to understand that whatever you think you know about the situation, the market (meaning stock and bond prices) already reflect all that is knowable, which includes the uncertainty about current and future government action or inaction. That doesn't mean that the market cannot drop in the future. As a purely hypothetical example, say the market is reflecting a 50 percent chance of a default on Treasury debt. In the end, it will turn out to be either 100 percent or 0 percent.
If Congress solves the problem and we don't default, it's likely that the market would rise sharply almost immediately. You would have missed the rally, and you would now have to decide if it was safe to buy at now much higher prices. On the other hand, if we do default the market will likely drop sharply (before you could act, if you had not already sold), and now you have to decide again what to do.
The real problem for investors is that while it's tempting to think we can benefit from jumping in and out ahead of the news, there's no evidence that you, or anyone else, can forecast with greater accuracy than what's referred to as "the collective wisdom of the market."
To repeat, when there is bad news market prices already reflect the bad news. That means that the market will only continue to fall if the new information it receives is worse than already expected. And if it's worse than expected, that means it's a surprise, which by definition is unpredictable. As to listening to some guru's forecast, here's what Buffett had to say in his 1992 letter to shareholders: "We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grownups who behave in the market like children."
Avoid stage-one thinking
Third, it's critical to avoid what economist and social theorist Thomas Sowell called "stage-one thinking," namely, that bad news means stocks must go down. As we discussed, bad news is already in prices. It's important to understand that if we are pushed over the precipice and markets crater, it's certainly possible that the impact of a crash would be what forces actions by government officials to finally resolve the issue. That is often what happens. For example, do you think that the Greek, Italian, Spanish and Portuguese governments would have taken the tough measures they adopted if there were not a crisis in their bond markets? Investors who engage in this stage-two thinking, anticipating that governments and central banks will take action to address, and hopefully resolve, crises, are able to avoid the panicked selling that so many individual investors engage in.
What would Buffett do?
The bottom line is this. The only way you're likely to get through both good and bad times, and earn the returns markets provide, is to have a well-developed plan that doesn't take more risk than you have the ability, willingness or need to take -- and be disciplined in adhering to it, rebalancing as required. Going to cash is never a good idea. In fact, it's a terrible idea, which is why you don't see Buffett doing it.
But if your find that your stomach is rumbling it might be that you have overestimated your ability to take risk, and a permanently lower equity allocation is in order. However, if you do act, be sure you're not making the change because of your view of current events. Instead, be sure that you're doing so because you overestimated your willingness or ability to take risk.
If the above isn't sufficient to convince you to avoid listening to your stomach, I offer the following suggestion. Before taking any action ask yourself the following six questions:
If you're honest with your answers, you'll come to the right conclusion.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
I've been getting many calls and emails from investors who are very concerned about the stock market, given the partial shutdown of the federal government and the looming crisis if the debt ceiling isn't lifted. The concerns are typically greatest among older investors who not only remember the bear markets of 2000-02 and 2008, but who also worry about having neither the time horizon to recover, nor the stomach to experience a repeat performance.
To begin, it's important to acknowledge that the concerns are real and well-placed. While a short-term shutdown of the government likely will have a minor impact on the economy, as it has in the past, no one can accurately forecast the consequences of a default on our debt. As a good example of the impossibility of knowing the answer to that one, in hindsight is safe to assume that the Federal Reserve would not have allowed Lehman Brothers to fail in the way it did in 2008. That was the event that precipitated the seizing up of the capital markets. And a repeat, or worse, performance could result if we defaulted.
The first important point to make is that crises like these are actually the norm -- they occur with great frequency, far greater than most investors are aware. For example, consider this partial list of major financial and economic crises investors have had to face over the last 40 years:
Meanwhile, according to historian Bonnie Goodman there have been 17 shutdowns in American history, concentrated between the 1970s and the 1990s.
The point of the lengthy list is to demonstrate that crises are the norm. They are in fact the very reason for the existence of the historically large equity risk premium (about 8 percent). Investors demand compensation for having to suffer through such periods, and do so with no assurance that things will turn out well. That's what we do know about crises -- that they occur with great frequency.
What we don't know is when they will happen, what will be the cause, how long the bear market will last and how deep will it be? In other words, your investment plan must incorporate the virtual certainty that you are going to have to live through many crises, perhaps about one every other year or so, and live through them with equanimity, without panicking and selling.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
By: Larry Swedroe
A call option contract gives the holder the right, but not the obligation, to buy a security at a predetermined price (the strike price) on a specific date (European call) or during a specific period (American call). A call is "in the money" when the current price of the stock is trading above the strike price and "out of the money" when the reverse is true.
You make the call
Many investors buy call options as part of their investment strategy. Unfortunately, it's likely they do so without knowing the returns to such a strategy. This is an all-too-common problem that isn't limited to options trading -- individuals don't know the returns on their investments. For example, the authors of the study "Why Inexperienced Investors Do Not Learn: They Don't Know Their Past Portfolio Performance" found that not only do individual investors dramatically overstate their performance, but performance is negatively related with the absolute difference between return estimates and realized returns.
In other words, the lower the returns, the worse investors were when judging their realized returns. They noted that while just 5 percent of investors believed they had experienced negative returns, the reality was that 25 percent did so!
With this in mind, Ryan McKeon, the author of the study "Returns from Trading Call Options," analyzed the performance of a strategy of buying calls. He used the bid-offer spreads to take into account trading costs (though commissions and other fees were not considered). This is important not so much because the spread is wide, but because the spread can be wide compared to the price of the option. The following is a summary of his findings:
Call option returns are generally low and decrease as the strike price increases.
Deep in-the-money calls generally deliver positive returns if held for a month, while all other calls deliver returns that are negative or not statistically significant from zero.
Deep out-of-the-money calls deliver lottery-like returns -- very large losses on average, with occasional, but rare, large and positive returns. Of the 709 options that fell into this category, 706 expired worthless, with the average return being -91 percent. The three that did produce a profit provided returns of 1,092 percent, 2,414 percent and 2,600 percent. Such returns provide the hope that leads to mostly very poor results.
The holding period didn't matter.
These findings are consistent with studies that show that individuals are risk seekers in that they have a preference for investments that have lottery-like distributions (such as "penny stocks," stocks in bankruptcy, IPOs and small growth stocks). They produce very poor results on average, but on rare occasions they provide outsized returns. The other explanation is that investors don't realize how bad such strategies are in terms of expected returns. If you've been buying call options, you no longer have that excuse.
The poor results of a buying calls strategy raises the question about the results of the other side of the trade -- selling calls and earning the premium. There are many investors who engage in this strategy by selling what is referred to as covered calls.
Covered Calls
A covered-call strategy requires the investor to write (sell) a call option on stocks that are in the portfolio. Essentially, the covered-call investor is trading off the upside potential (above the strike price) of the equity investment for an up-front fee and reduced (by the size of the call premium) exposure to downside risk.
Marketers of covered-call strategies demonstrate the efficiency of the strategy through the "Sharpe ratio," a measure of the return earned above the rate of return on riskless short-term U.S. Treasury bills relative to the risk taken, with risk being measured by the standard deviation of returns. While the Sharpe ratio is a useful risk-reward measurement tool, it defines standard deviation as the measure of risk. While standard deviation does measure the volatility of returns, volatility is not the only measure of risk. Investors care not only about volatility, but also about other characteristics of the distribution of returns, such as skewness.
Skewness measures the asymmetry of a distribution. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from the mean than are values to the right of the mean. For example, the return series of -30 percent, 5 percent, 10 percent, and 15 percent has a mean of 0 percent. There is only one return less than zero percent, and three higher; but the one that is negative is much further from zero than the positive ones. Positive skewness occurs when the values to the right of (more than) the mean are fewer but farther from the mean than are values to the left of the mean. As we have already mentioned, the evidence suggests that investors prefer assets with positive skewness, like the lottery ticket. They generally try to avoid assets with negative skewness.
This leads us to the question of what impact does a covered-call writing strategy have on the potential distribution of returns. Does it shift the distribution away from a normal one, rendering the use of measures such as the Sharpe ratio less meaningful? The study, "Covered Calls: A Lose/Lose Investment," covering the nine-year period of February 1987 to December 1995, found that that while covered-call strategies did produce a lower standard deviation than did an indexing strategy, because the covered-call strategy eliminates the upside potential it produces negative skewness of returns (the kind investors dislike). For example, using a strategy of one-month covered calls produced a negative skewness of 4.6 versus a negative skewness of just 1.1 for a buy-and-hold indexing strategy. The negative skewness calls into question the relevance of the Sharpe ratio for this strategy.
Trim the fat
While it is true that a covered-call strategy does reduce kurtosis ("fat tails"), the problem is that it eliminates the potential for the good fat tail (the one to the right), while having no impact on the risk of the bad fat tail (the one to the left) occurring. Risk-averse investors would much prefer to eliminate the risk of the left fat tail (bear market) while accepting a smaller right fat tail (bull market).
Unfortunately, there are other negative features of covered-call writing strategies which include tax inefficiency and high transactions costs. As an alternative, I recommend investors consider lowering their equity allocation while increasing their exposure to small and value stocks.
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