How times have changed. I remember when a basket of 15 to 20 stocks in different industries constituted a well-diversified portfolio. But holding any basket containing any number of sectors provided little protection during the 2008-09 global financial crisis.
What went wrong with conventional wisdom, or, more specifically, with the way most investors embraced it? In simple terms, investors never properly defined “diversification.” The 15 to 20 stock rule was never meant to imply that an all-equity portfolio constitutes proper diversification. What the term really means was that a portfolio of 15 to 20 stocks diversified across a broad number of industries and sectors substantially eliminates the risks associated with any particular company.
What professional investors have always known is that company-specific events are only one of the risks associated with holding a portfolio of stocks. Equally important is market risk. As the market rises and falls, most stocks tend to move in the same direction. Within an all-stock portfolio, there is no way to eliminate market risk – no matter how many stocks you hold.
In the past decade, investors have come face to face with the principle that market risk is a critical factor when evaluating specific asset classes. Stocks are influenced by changes in market conditions, such as the economy, interest rates and investor sentiment. So too are bonds and cash, albeit much differently. To mitigate market risk, traders need to build portfolios that include multiple asset classes. Holding cash, bonds, stocks and alternatives will go a long way towards reducing the market risk associated with any one asset class.
This diversification strategy is more important today than it has ever been. That’s mainly because there’s been a dramatic shift in the average level of volatility associated with company-specific issues relative to broad equities indices.
In other words, we now know that company-specific risk cannot be quantified accurately. This means that, at best, the options market recognizes that specific events cannot be forecast. On the other hand, we also know that the average gyrations within the stock market have stayed within certain ranges, give or take catastrophic events such as the global financial crisis.
Since early 2000, stock volatility associated with individual companies has risen, while the volatility on broad market indices has declined. Reducing risk in equities holdings in this environment means that you probably need to hold 40 to 60 stocks, rather than the traditional 15 to 20.
But even adopting that strategy does not eliminate market risk. An equities portfolio, no matter how many stocks are in it, will still be influenced by market risk. That risk is either becoming a bigger problem or a benefit, depending on whether we are in a bull or bear market cycle.
The volatility index (VIX) measures the level of option premiums on the S&P 500 composite index. VIX provides us with a quantifiable snapshot of how much risk investors are pricing into the equity markets. The five-year trend (using the 200-day moving average as the trend) has been hovering between 15% and 20%.
What’s interesting is the changing relationship between market and company-specific risk. As bullish sentiment becomes more entrenched, the gap between index option premiums and the premium on the average equity option has been widening.
Volatility for the two – equity and index options – has been declining since the financial crisis, but the relationship between the two has been widening. The average equity option is trading with an implied volatility of 40%, vs the current 16% for the VIX.
In other words, the current trends in the option markets suggest that market risk represents less than about half of the total risk associated with equity investments. We can use this information in a couple of ways.
First, we can compare individual equity options against VIX to ascertain how much risk is inherent in a specific stock or sector relative to the broad market. More risk requires greater diversification.
Understanding that principle sets the stage to promote the value of diversification within an asset class and, more important, within a portfolio that includes multiple asset classes.
If we accept these tenets, then advisors need to spend more time focusing on ways to reduce market risk, both within a specific asset class and in spreading portfolio risk across multiple asset classes.
Second, in terms of employing option strategies, there is an opportunity if one can afford to build a well-diversified portfolio of, say, 40 to 60 stocks, and then write individual equity options against the stocks in the portfolio. Remember that the options on the average individual stock are trading at 40% implied volatilities, vs 16% implied for the index. By doing so, clients can collect premiums that are priced relative to company-specific issues while presumably holding a portfolio that has all but eliminated company-specific risk.
The problem is that the cost to implement this theory is much too high for most individual investors. For them, the approach might be to hold an exchange traded fund that employs covered call writing strategies as one of the equity assets in a portfolio.
If you have a portfolio that is 50% equities and 50% fixed-income, you might consider an allocation that is 40% equities (or equity mutual funds), 20% in a covered call writing fund and 40% in bonds. IE
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