Archive for May, 2009

Using synthetic longs & shorts to reduce portfolio risk

Thursday, May 28th, 2009

This is the second article in a continuing series devoted to strategies designed to reduce portfolio risk, reduce position cost, or both. Many of these strategies involve options replacing some or all of the desired position. They are called synthetics since the shape of their risk/reward profiles are identical to that of the underlying position. Yesterday, for example, we looked at how a synthetic long call, achieved by buying the stock (or futures) plus a put option, can be used as short-term protection against event risk.

Yesterday’s focus was on risk-reduction, but today we’ll be turning our attention to cost reduction which, when you really think about it, is just another way of reducing portfolio risk (since you’re risking less money while expecting the same reward).

Let’s see how we can do that.

Synthetic longs
A synthetic long simulates the risk/reward profile of a long position. It is composed of an at-the-money (ATM) long call and an ATM short put, both with the same shelf lives (expiration dates). The reward is unlimited to the upside, just as a long stock would be. Unfortunately, the risk to the downside is just as great as with a long position, but as we’ll see in a minute, there is a way it can be mitigated in the synthetic strategy.

Let’s consider an example ripped from today’s charts. [Note: Commissions and other costs are not included in the following calculations.]

Google (GOOG) put in a local bottom on March 9th trading around $300. On that day, the June 300 call option closed at $28.40 and the June 300 put closed at $37.00. To buy 100 shares of Google on that day at $300 a share would have cost you $30,000. That’s a chunk of change for such a small position. Let’s see how much the equivalent synthetic position would have cost.

Since 100 shares of stock represents one options contract, it would have cost you ($28.40 – $37.00) x 100 = -$860 to enter the position. The negative number means that you would have actually gotten paid to take on that position. In effect, you’re saving $30,860–gloryosky! How’s that for a reduction in your cost basis?

Let’s see how you would have fared if you had closed out your position two days ago on March 26th.

Google stock closed at $404, so that means you would have made ($404 – $300) x 100 shares = $10,400 for a 35% return. Not too shabby at all.

Now let’s look at the equivalent options position. On March 26th, the call option closed at $104.75 and the put closed at $0.20 giving a profit of ($104.75 – $0.20) x 100 = $10,455. Adding in the cost of the initial credit, your total profit would be $11,315—even better than the stock position. (Actually, I find this quite interesting because the volatility has decreased quite a bit since the beginning of March and I would have expected a lower return.)

So, the choice is yours: Would you rather have spent $30,000 to go long Google or would you rather get paid $860 to reap the same reward for a similar risk? This is the major upside of the synthetic long.

But there are a couple of downsides, too. Sometimes instead of getting a net credit you’ll be paying a net debit to enter the synthetic position. That occurs when the call is more costly than the put. In this instance, you’ll need the stock to rise above the call strike price plus the debit just to break even on the trade. For example, if the price of the call and put options had been reversed in the above example, Google stock would have needed to reach $308.60 just to break even on the trade. This is the one advantage of holding the stock position instead of the synthetic.

Limiting the downside risk on the synthetic
Selling an uncovered option can be a very risky proposition. If Google had continued to slide instead of turning to the upside, the put option would have steadily increased in value while the call decreased in value. The break even point for this trade is $291.40, so you would have been protected until then, but once the stock moves below that point, you’ll start to incur a loss. You can stop this loss by doing one of two things: close the entire position or purchase a lower strike put. You can buy this lower strike put any time, but some prefer buying it when they open the synthetic position. (Buying a lower strike put and selling a higher strike put is known as a bull-put credit spread in options parlance.)

For example, let’s suppose that in addition to our synthetic long we had also bought the June 290 put at a cost of $31. Our cost basis would have swung from a net credit of $860 to a net debit of $2240—still a whole lot less than $30,000. Our break even point would now be $322.40, and that’s quite a difference. It just made the trade riskier on the upside. If we had sold out this position on March 26th, the price of the 290 put was $0.10 so that our overall profit would have been reduced to $8225—a 267% return. [(($104.75 – $0.20 + $0.10) x 100) – $2240 = $8225]

Let’s see what would have happened if this trade went in the reverse direction.

You would lose money if, at options expiration, the stock closed below $322.40. Let’s suppose it was trading at $290 at expiration. Here, all of your options would have expired worthless and you would have been out your initial investment of $2240. Had you just owned the stock, your loss would only be $1000 since you bought it at $300. In fact, you would have done better on the pure stock play even if it had dropped as far as $277.60 but below that the loss on the stock would become greater. The maximum loss for the synthetic position is capped at the initial credit of $2240.

Synthetic short positions
The synthetic short is made up of buying an ATM put and selling an ATM call, both at the same strikes and expiration dates. It’s the same as the above strategy except in reverse. Note that the risk of this position is unlimited just as in the underlying short position. In this case particularly, I would strongly recommend that you write a bear-call credit spread which involves buying a higher strike call. This would greatly reduce your loss should the trade go against you.

Discussion of Risk
While synthetic positions can reduce portfolio risk by reducing the percentage of total dollars allocated to one position, the cost of the position can increase the position risk if the initial cost is a debit. (The position won’t begin to profit until the break even point is reached.) However, if you can enter a synthetic position at a net credit as in the Google example above, you’ve effectively lowered your break even point and decreased your downside risk. Getting into a synthetic position with a net credit (or a small debit) is the best use of the strategy.

You can see that using options to simulate long and short stock (or futures) positions can be very helpful especially to investors with smaller account values who wish to participate in the movement of higher-priced stocks. Unfortunately, Berkshire-Hathaway stocks (BRK.A, BRK.B) are not optionable.

Using synthetics to minimize event risk

Wednesday, May 27th, 2009

Much is made about making profits but protecting them is equally important, especially in these uncertain economic times. In that regard, I’ll be writing the occasional article on risk reduction strategies that will show you ways to protect existing positions as well as introducing some low-risk and even riskless trades.

To kick off this series, I’m devoting today’s blog to the discussion of how synthetics can reduce event risk. If you don’t know what any of this means, don’t worry for it will all be explained in due course.

What is a synthetic?
For any conceivable stock or options position there is an equivalent synthetic position that uses a combination of the underlying instrument plus call or put options to achieve an identical risk/reward profile. Although synthetic positions require at least two transactions (and hence two commissions as opposed to one) to set up, they are more versatile in terms of making trading adjustments than their underlying equivalent. With a combination of timing, trading skill, and perhaps a dose of luck, a seasoned options trader can potentially profit from both sides of the trade while still providing the benefits of lowered risk and, for the cases where the underlying is completely replaced by options, a lower entry cost.

Today we’ll be looking at one way you can protect an individual stock (or futures) position using synthetic calls and puts.

Synthetic calls
The synthetic call is used to protect long positions on optionable stocks and futures contracts. It is constructed by buying the stock and an equivalent number of at-the-money (ATM) put options. (Remember that 100 shares of stock = 1 options contract.) The synthetic call is just another name for a protective put. The risk/reward profile is identical to that of a long call. (Click here to see the profile of a synthetic call.)

Let’s look at a recent example of how using a synthetic call on the SPY would have worked just before the release of yesterday’s Consumer Confidence Index.

Suppose you’re bullish on the direction of the market and have been holding a long position in the SPY, the S&P 500 tracking stock. You knew the Consumer Confidence report would be released on Tuesday, May 26 at 10am ET and were (justifiably) concerned that a bad number could derail the market and wipe out your gains. What could you have done to ease your mind and protect your position?

Just ten to fifteen minutes before that number was to be released, you could have picked up the June 85 put for $2.85 to $2.95 per contract and sold them ten minutes after the release for $2.25. This put insurance would have cost you 65 to 75 cents per share, but it was more than covered by the corresponding gain in your SPY position ($1.12 – $1.46 during the 9:45am to 10:10am timeframe). Your net gain would have been in the 37 to 81 cents per share range—a pretty decent return in less than a half an hour! Of course, no profit is realized until the underlying stock is sold, but at least you were protected against potential damage had the number been bad.

And what if the Consumer Confidence number had been ugly? Had the market turned negative, your put would have become more valuable, offsetting the loss in your stock. In fact, the maximum loss you could ever incur with this strategy is limited to the price of the puts plus commission costs whereas your maximum loss without put protection is equal to your entire initial investment. I’d say that’s worth it.

When to initiate put protection
The above example shows how the synthetic call would have worked for a key economic event. Other events where this strategy makes sense is on a stock where a negative or an even less than stellar earnings report could push it over a cliff (think Apple (AAPL) or Google (GOOG)). Also, drug companies with key drugs nearing the end of a study phase also make good protective put candidates especially small biotechs with only one or two drugs under development.

I could have used protective puts in two stocks in my M&A portfolio. When vacation timeshare company Bluegreen (BXG) announced that the company seeking to acquire it needed more time to do their due diligence, that was when the alarms went off and  I should have bought a protective put. It sure would have saved me from a 53% loss I finally had to swallow!  The other position I should have protected was Rohm-Haas (ROH). When acquiring company Dow Chemical (DOW) announced that it was having financing difficulties was the time to protect the position. (As it turned out Dow made good on the deal and I was spared another humiliating loss, but it came at the expense of a lot of mental anguish.)

What type of protection to buy
Now that you know when to buy protection, what strike and expiration should you go for? If you’re looking only for very short term protection like in the above example, buy the front-month option with the requirement that you won’t be holding it for more than a couple of days, max. The reason for a short holding time is that options begin rapidly losing time value about 30 to 45 days before expiration. On the other hand, if your underlying stock is highly volatile and you think there’s a good chance you could profit from an increase in the price of the option, then I’d purchase one with an expiration date at least three months in the future.  This gives you more time without having to worry about time decay eating away at the value of your option, but it probably won’t do much to help you with the issue of decreasing volatility which also affects options pricing.  An option can lose value even if the stock does nothing because of a decrease in volatility, so keep that in mind, too, especially since the volatility of the overall market has been declining.  

As for the strike price, it depends on how much insurance you want and what you paid for the underlying. If your stock has increased in price, you could purchase a put with a strike near the initial cost. The lower strike option will be cheaper but now you risk losing all of your current profit. In buying insurance, there’s always a tradeoff between cost and risk. The choice is up to you.

Synthetic puts
The synthetic put can be used in a similar fashion to protect short positions. In this strategy, you would buy the equivalent number of call contracts to balance your short position. Here, the risk/reward profile is the same as for a put option. Your maximum loss is limited to the price of the call plus commissions whereas the maximum loss of a short position is theoretically unlimited. It’s for this very reason that synthetic puts are a good idea, especially in these volatile markets.

We’ve seen that event risk can be mitigated by the judicious application of options. As with any options strategy, please paper-trade it first before putting on real money.

Here’s to a more restful night’s sleep!

MPT Redux-Part III: Asset Class Correlations & Fund Proxies

Thursday, May 21st, 2009

Dr. Kris is out of town this week and is rerunning her series written by guest contributor, Professor Pat, on the topic of Modern Portfolio Theory. These posts originally appeared in the April 21-24, 2008 blogs. The content has been edited and data updated to reflect current values where appropriate.

Today is the final installment on Modern Portfolio Theory (MPT) where we’ll be looking at the correlation among asset classes. We’ll also provide you with proxies for these asset classes drawing from the mutual fund and ETF pool so that you, too, can construct your own portfolio.

Correlation Among Various Asset Classes
Additional asset classes added for consideration should preferably be uncorrelated or negatively correlated to the other asset classes for best results. The relation between how asset classes or securities move relative to each other is defined by what is known as the Pearson correlation coefficient. The table below shows the Pearson correlation coefficients for each of the asset classes to one another.

A value of +1 indicates perfect correlation while a value of -1 would reveal total negative correlation in the sense that when one asset goes up in value the other would go down in the same proportion, and vice versa. A value of zero demonstrates no correlation between the two asset classes; that is, they behave independently. (Note: The Pearson coefficient assumes a Normal distribution of data as we discussed yesterday.)


As expected, all of the stock asset classes have high correlations with each other and low correlations to government bonds, especially T-bills, where the correlation there is slightly negative. As for bonds, the Long & Medium Term Government, Corporate, and International Bond asset classes are highly correlated with each other. T-bills, on the other hand, don’t show much of a correlation to any other asset class except for Medium Term Gov’t and International Bonds.

What this table confirms is that there is a sufficient lack of correlation between the various asset classes to present a suitable set of alternatives from which to compile a portfolio that can be counted on to behave according to the precepts of MPT.

Historical volatilities & returns of the asset classes
Let’s now look at a comparison of the returns and risks of an optimally allocated portfolio with those that contain just one asset class. The table below shows the average annual return and volatility of each of the nine asset classes using data from 1928 to the end of April, 2009.


You can see that to get a higher return requires that the investor take a higher risk. To achieve higher returns, MPT would allocate the portfolio chiefly among the stock and REIT asset classes, with some component of bonds thrown in to minimize risk. This is why young investors should concentrate their portfolios into these asset classes while those nearing retirement should focus on minimizing risk to preserve needed capital. Bonds are the least risky asset classes which is where the older investor’s portfolio woukd be concentrated. But, MPT would likely throw in a small percentage of stocks in order that the desired return can be achieved.

For example, we saw yesterday that the most conservative portfolio of 99.6% in T-bills would return an average of 3.7% annually with an associated risk of 0.9%. However, by increasing our risk by only 0.1% to 1.0% we can achieve a return of 4.0%, or 0.3% over the previous return, just by adding Medium Term Gov’t bonds to the mix.

You can see why it’s important to not only include a mix of asset classes of differing correlations but of differing expected returns. MPT uses the higher volatility (i.e. the higher return) asset classes to maximize portfolio return and uses the correlation coefficients to minimize portfolio risk. It’s important to note that no portfolio can achieve a higher return than that of its highest returning asset class.

There are many interesting observations to be gleaned from these tables such as the high volatility of REITs and the counterintuitive performance of Long-Term Corporate bonds versus Long-Term U.S. Government bonds where Corporate bond returns display the expected risk premium but the volatility is actually lower. Perhaps a closer examination of the actual composition of the comparative fund holdings might provide an explanation for this.

Asset Class Proxies
An investor interested in forming a portfolio along the lines of the nine asset classes discussed here will find the following Vanguard funds as suitable proxies for some of them.* Vanguard does not currently offer an International Bond fund so a T. Rowe Price no load fund with a reasonable expense ratio is listed as well as one by Oppenheimer.

The electronically traded funds listed in the following table are also suitable proxies for the named asset classes.

ETF or Mutual Funds?
This is really a subject for another blog but I thought I’d touch on it because it’s relevent. One main reason to use mutual funds, especially if you hold many funds within the same fund family, is that you can exchange among them at little or, even better, no cost (like Vanguard).

One reason to use ETFs is that you don’t have to wait until the end of the day to transfer in and out of them because they trade exactly like stocks. (But also like stocks there’s a spread between the bid and ask prices.) If you’re judicious in your trading, you could actually do better in the transaction, especially if you’re trading among negatively correlated asset classes.

The other reason to use ETFs is that, in general, they’re not subject to as many tax consequences as mutual funds. This is because that instead of selling stocks like a mutual fund is forced to do, and by so doing incur short or long-term capital gains, the equivalent ETF has the legal right to “swap” in and out of stocks avoiding capital gains altogether.

The choice is yours, and you should do your homework on both strategies.

In summary, we have shown that diversification provides real measurable benefits and that you, the investor, can use the tools of MPT to quantitatively measure reward versus risk in forming an investment portfolio that is suitable for your circumstances.

Note: All of the above calculations were determined using the SMC Analyzer. To see how the Analyzer achieved these results, click here to view the Demo.

*Disclaimer: No one at the StockMarketCookBook has any affiliation with Vanguard, but we like their low management fees and the ease with which one can move among their funds at no cost. You can check out more about them and other mutual funds and ETFs at Morningstar.

MPT Redux- Part II: Asset Allocation

Wednesday, May 20th, 2009

*Dr. Kris is out of town this week and is rerunning her series written by guest contributor, Professor Pat on the topic of Modern Portfolio Theory. These posts originally appeared in April 21-24, 2008. The content has been edited and data updated to current values where appropriate.

Yesterday, we saw that the aim of MPT is to provide the investor with a desired return value while minimizing risk. It achieves this by allocating portfolio resources among appropriately selected asset classes of varying volatilities and inter correlations. Today we’ll look at some actual data and examine the results.

Note that the data presented here represents monthly data collected from 1928 to the present. You probably won’t find these results anywhere except perhaps in institutions of higher learning or in large brokerage houses. This is a rare opportunity to view it first-hand.

Portfolio Construction: Selection of Asset Classes
The core philosophy behind MPT is to construct a portfolio of uncorrelated (or relatively uncorrelated) asset classes. Two assets are said to be uncorrelated if they react differently to market events. For example, the stock market and the bond market are two asset classes that are relatively uncorrelated as bonds usually perform better when the stock market is suffering and vice versa. The point of MPT is to construct a portfolio consisting of relatively uncorrelated assets in ratios that will give the investor the return he expects while minimizing risk.

In order that the recommendations provided by MPT be robust, it’s necessary to have enough asset classes of varying risks and inter correlations. The reason to include higher risk asset classes such as small-cap/high-growth stocks is that they’re precisely the ones that can provide the investor with higher returns, if needed. It’s also important to include a mixture of relatively uncorrelated as well as negatively correlated asset classes, such as stocks and bonds. The nature of the correlations among the asset classes is the factor that minimizes risk.

Description of the Selected Asset Classes
We’ve selected nine asset classes that are not only popular investment vehicles but also represent a collection of asset classes with the required volatilities and correlations. They are the following:

1. Large U.S. Stocks as currently represented by the S&P 500 Index.
2. Small U.S. Stocks defined by the Dimensional Fund Advisors (DFA) Microcap Portfolio.
3. Long-Term Corporate Bonds measured by the Citigroup High-Grade Corporate Bond Index.
4. Long-Term Government Bonds, a 20-year Treasury Bond.
5. Intermediate-Term Government Bonds, a 5-year Treasury Note.
6. 30-day U.S. Treasury Bills
7. Real-Estate Investment Trusts (REITs) defined by the DFA US Real-Estate Securities Index
8. International Stocks per the DFA Global Equity Portfolio
9. International Bonds per the DFA 5-Year Global Fixed Income Index Fund

Optimum Asset Allocations at required levels of return
Using annual total return performance data for each of these individual asset classes from January,1928 through April, 2009 and applying the mathematics of MPT to that data, the following table can be constructed:
To use this table, you, the investor, would choose the desired rate of return (given in the first column) that lies within your tolerance for risk. The risk is defined by the standard deviation located in the second column. You should not merely chase the highest potential return but also consider your ability to accept years in which sharp draw-downs in the overall portfolio value may occur. It is of utmost importance to note that variations in returns are smoothed out and tend towards the desired return, but this usually requires a long time horizon—sometimes on the order of 40 to 50 years.

Portfolio allocations for investors with shorter time frames
Investors nearing retirement will need to avoid the possibility of sharp declines happening just when they will be needing to withdraw funds. In this case, an aggressive allocation should be converted to a more conservative one. For example, the average return from the most conservative portfolio is 3.7% which is achieved with a portfolio of 0.1% Small Stocks, 0.2% Long-Term Corporate Bonds, 0.1% International Stocks, and the bulk of the portfolio, 99.6% in Treasury Bills, an essentially riskless asset class.

This represents the safest possible portfolio in that it provides the smallest variation in return from year to year. In any one year there is an approximate 68% chance (see the last installment of this article) that the actual return will be within one standard deviation. In this case, the return can be expected to vary between 2.8% and 4.6% (3.9% +/- 0.9%) In other words, the chance of a decline in overall portfolio value over any given year is small.

Portfolio allocations for those with longer time frames
A more aggressive investor with a longer time horizon, such as a person in his 20s -30s, might choose a higher yielding allocation but he must also be willing to accept the risk of short-term market declines or intermediate-term lackluster returns. This must be done so that the portfolio will be properly invested during those times where the previously underperforming assets become out-performers.

Portfolio allocations for those with intermediate time frames
Most investors will want to choose an allocation that moderates the risk while still providing a healthy average return. Returns between 7% – 9% are particularly attractive because as there’s a chance of a small decline in any one year, there will be reliable gains for most years over time. Right now, these portfolios would be allocated among the Small-cap stocks, Medium-term government bonds, and International stocks.

Observations gleaned from the above asset allocation table
Small stocks have historically produced the highest overall returns over the long haul as indicated by the table. To achieve the higher returns, the portfolio must be heavily weighted in small-cap stocks. But as MPT shows, higher returns come only with higher risk.

In 1973, for example, the loss in small stocks was about 31% followed in the next year by another 20% hit. The following nine years, however, saw a nice recovery with a whopping average annual appreciation of 36%. Regardless of your risk tolerance, the table does indicate that some exposure to small-cap, high-growth stocks is advantageous.

It is interesting to note that the above table recommends that Large-cap stocks, Long-Term Government Bonds, REITS, and International Bonds are not an attractive investment to hold in any portfolio right now.

In the next MPT installment, we’ll suggest some proxies for these asset classes. We’ll also look at the correlation table between them.

Modern Portfolio Theory Redux: An Introduction

Tuesday, May 19th, 2009

*Today’s blog and the next few to follow are reposts of those blogs written last year on the topic of Modern Portfolio Theory, or MPT. They were written by the StockMarketCookBook’s resident academic guru, Professor Pat, but Dr. Kris has edited and updated them as needed. Since MPT is an integral part of the SMC Analyzer, we felt that including several brief tutorials on the subject would be helpful to those readers interested in learning more about the technical foundations of the Analyzer.

This week, Dr. Kris is out of town playing Aunt Kris at her nephew’s high school graduation. (Aunt Kris is proud to mention that he’s graduating at the the top of his class. Looks like he’s following in his Auntie’s footsteps proving that brains as well as modesty runs deep in the family’s bloodlines.)

We’ll be back to our regularly scheduled blogging next week. Have a safe and happy Memorial Day!

Modern Portfolio Theory (MPT): The Background
Modern Portfolio Theory (MPT) was first conceived by Harry Markowitz in 1952. For his inspiration and hard work he was awarded the 1990 Nobel Prize in Economics. Markowitz proposed that investors should be concerned not just with investment returns but also with investment risk, and put forth a strategy on how to achieve optimum performance using a mathematically determined allocation of asset classes.

MPT asserts that investors could and should balance the returns they receive on their investment portfolios with the risks those investments present. As such, and for the first time, a way to actually quantify the notion of risk was available. The new idea was that risk could be equated with volatility or the variation in returns from one time period to the next. The beauty of MPT is that it was also now possible to take this one step further and mathematically determine an optimum investment portfolio that delivers the desired long-term rate of return while simultaneously minimizing risk. The benefits of portfolio diversification in terms of risk reduction could now be mathematically derived.

Correlation and volatility
An investment portfolio consists of various asset classes (e.g., stocks, bonds), some of which appreciate and some of which may depreciate within any specified time interval. MPT uses the concepts of volatility and correlation among asset classes in its computations. Briefly, volatility is the rate of change in the value of each class. Correlation is a measure of how two asset classes move in relation to each other. For example, investments that move in tandem with each other are positively correlated; those that move in opposite directions such as stocks versus bonds are said to be negatively correlated; while those whose movements are independent of each other are said to be uncorrelated. MPT takes advantage of this fact to determine not only which investments to invest in but how much of each you should hold relative to each another.

The concept of MPT as a type of portfolio insurance
MPT can also be thought of as a type of portfolio insurance. As an investor, you hope that all of your investments will increase but you also know that this is an unrealistic expectation. MPT insures your portfolio against unreasonable losses by holding asset classes that can counteract losses in one class with gains in another. The way to achieve this is to select investment vehicles that are uncorrelated with each other. A properly diversified portfolio also includes relatively low yielding assets (like treasuries) that can be counted on to produce steady and reliable gains. An important assumption of MPT is that the future will, on average, be just like the past.

[Shameless plug: This assumption is proving to be a major drawback to MPT, especially in recent years. That’s why the addition of market timing to the MPT model not only increases potential portfolio returns but at significantly reduced risk. This is precisely the function of the SMC Analyzer*.]

MPT: The Theory
The techniques that are used in MPT to solve the optimum asset allocation problem is a branch of mathematics known as quadratic programming. There are two inputs to this program: 1. The actual historical returns of the various candidate assets input as a time series, and 2. The desired average rate of return that portfolio is expected to produce. The output of the calculations is the percentage to be ascribed to each asset class so that the entire portfolio will produce the desired return while minimizing risk. MPT quantifies that level of risk with a number called the standard deviation.

The standard deviation, denoted in statistical terms by the Greek letter σ, is a number that provides a bracketed range for the desired return. One standard deviation represents approximately 68% of the values around the expected outcome.

A basic assumption in MPT is that investment returns follow a pattern known as a normal distribution commonly found in natural processes.** Graphically, it forms a shape that looks like a bell as depicted in the illustration below. For example, if the desired annual rate of return is 10%, MPT might reveal a certain asset allocation strategy that would result in a minimum standard deviation of 11.7%. This means that approximately 68% of the time the actual return in any one year would fall in the range from -1.7% to +21.7%. (10% +/- 11.7%)

To be very confident about the exact range of one’s returns, we can again look to the normal distribution which also tells us that about 95% of the time the return the average return will be within two standard deviations of the mean, or in the above case between -13.4% to 33.4%.

The image below depicts these concepts. The dark blue region is one standard deviation,and the light blue region extends to two standard deviations. The symbol μ on the image is the average rate of return, or 10% in our example.


Investment philosophy
MPT is a useful tool for investors who prefer to remain somewhat passive in their investment activities. That is, they are not concerned with market timing. The optimum asset allocation technique tells them that they can remain comfortable with fluctuations in the market and limit their activities to monthly or even quarterly rebalancing to preserve the correct allocations following increases or decreases in the performance of individual assets held.

When we get to presenting the reality of these results, the data will confirm what everyone already knows: there is no such thing as a free lunch. That is, the higher the rate of return you wish to achieve, the more risk you have to be willing to take on. But we will see with numbers just how much more risk we’ll have to take to achieve those higher returns or how much return we need to give up to achieve more safety.

The next installment in this series will present actual results using common investment classes and will show you how to assemble a portfolio needed to achieve your desired rate of return. Stay tuned!

*For more details on MPT, take the SMC Analyzer Features Tour.

**Post-Modern Portfolio Theory (PMPT) impudently challenges this assumption, but for right now, it’s a good-enough one.

Two for the road

Thursday, May 14th, 2009

I’m feeling a bit burned out writing about market timing as applied to modern portfolio theory and thought I’d divert my attentions to what’s happening in the here and now. In the course of chart surfing today, I came across a couple of  interesting stocks that deserve a mention. Consider this a palate-cleansing blog both for you and for me.

Two stocks on the warpath
The first stock that has been blazing an upward trail is small-cap Chinese wireless provider, KongZhong (Nasdaq: KONG). Its daily chart below shows that its been a juggernaut, moving steadily upwards since its 10/10/08 low at $2.31. It closed today at $7.63, up over 230% on more than six times normal volume.


Apparently, somebody knows something. Volume for the past month has, for the most part, been trouncing its normal volume of 95,000 shares. Previously, institutional ownership has been a neglible 0.20% of the float, but perhaps that’s changing. Could it be that someone besides the one analyst covering it is paying attention to the fact that the company has been steadily raising guidance over the past several quarters?

Note that the stock tends to bounce off its 30 dma (the blue line). Right now, it seems to be a bit overextended so if you want to play it, you might want to wait until it pulls back. Also note that if you look at KONG on a weekly chart you’ll see that it faces resistance at the major dollar levels of $8, $9, and $10.

The second is Diedrich Coffee (Nasdaq: DDRX). It was one of the coolest coffee haunts in the ten block commercial corrider near me (as well as the closest) that included one Peet’s, three Starbuck’s, one Coffee Bean and Tea Leaf, one Seattle’s Best (my favorite spot that ultimately morphed into a trendy baby clothing store), plus an independent gourmet espresso shoppe. Starbuck’s (SBUX) eventually bought out all of the Diedrich’s shops in the Southern California area including mine and finally had to shutter because it couldn’t compete with the other two SBUX’s that were within 100 yards of it.

So, I’m scratching my head looking at the chart below and wondering what is suddenly up with Diedrich’s. The company has been closing out its retail locations, including its Gloria Jean brand, and going the wholesale route. The stock chart looks like the 50-1 Kentucky Derby winner, Mine That Bean. Just two months ago it was trading at all of 38 cents, and today it closed at $12.56, only 3200% above that. Guess the insiders who bought near the stock low knew what they were doing–talk about winning the trifecta!


The company’s major competitors are Starbuck’s (SBUX), Peet’s (PEET), and Green Mountain Coffee Roasters (GMCR). Perhaps Diedrich’s management understood that real-estate was in a bubble and wisely sold out. I don’t know about that, but I do know that its stock chart is defying those of its competitors and is the only one trading at an all-time high. Can it keep up this pace? I’m not sure but it looks like somebody’s gobbling up the stock as it’s been trading well above its average daily volume of 120,000 shares for the past three weeks.

The stock may be ready for a breather as evidenced by today’s topping tail. Waiting for a pull-back before entering a long position wouldn’t be a bad thing, especially as the stock has enjoyed a huge run-up.

But I still want to know the inside scoop with this company. Something’s brewing, and it’s not just java.

Note:  Dr. Kris has no positions in any stocks, options, or ETFs expressed in her articles unless otherwise stated.  The exception is with her M&A  (MANDA) fund in which she does own shares as stated.

Market-timing versus buy-and-hold asset allocations at critical market periods

Wednesday, May 13th, 2009

In the previous blog we looked at how the addition of an optimized market timing scheme to the asset allocation model provided by Modern Portfolio Theory (MPT) not only increases portfolio returns, sometimes substantially, but also at lower, and sometimes greatly lower, risk.

Today we’ll be expanding on yesterday’s topic of comparing two portfolios both with assets allocated according to the tenets of MPT. The first portfolio is allocated according to the traditional buy-and-hold strategy, and the second uses a market timing oscillator, the CCI, that is specifically optimized separately for each of the nine asset classes under consideration. [See the previous blog for the list of those asset classes.] We looked at the performance of each fund starting with equal dollar amounts in January of 1990 with the requirement that the funds attempt to generate at least a 10% average annual compounded return. The analysis was run through April, 2009.*


The difference in results was staggering. The buy-and-hold portfolio, which is the one that is used in typical MPT calculations, only was able to attain an average compounded return of 4.2% compared with the market timing portfolio that achieved a comparable return of 9.8%. Moreover, the risk as given by the standard deviation was 15.8% for the first portfolio compared with only 6.9% for the market timing one—a huge difference!

Where the market timing portfolio really outperformed the other was during the dot-com bubble in 2000 and in the recent mortgage meltdown in late 2007. How did it accomplish this?

Let’s examine what the SMC Analyzer would have recommended just before and during each of these major market downturns.

Just before the dot-com bubble burst
The first period we’ll be examining is the bull market preceding the internet bubble burst. The tables below show how the SMC Analyzer would have allocated assets for a buy-and-hold portfolio which is one that is long during all market conditions; and a market timing portfolio which is long when the CCI oscillator is positive for that asset class and in T-bills for that class when the oscillator is negative.


Here, still, the risk is much less for the market timing model (the second table): 10.1% compared with 18.2%. And the table shows you one reason why: the percentage of funds allocated to stocks is much less in the market timing model as compared with the buy-and-hold one.

[Note: The first row in each table shows you the percentage of your portfolio that MPT recommends you allocate to each class; the third row tells you how that percentage should be invested. In all of the above, a long position is recommended for each class.]

Let’s see move ahead a bit in time to the middle of the dot-com decline to August, 2001 and see if there’s been any change to these allocations.

Mid-dot-com decline
The following tables show that the buy-and-hold portfolio has become riskier, mainly because in order to meet the 10% return, MPT must allocate more funds to those asset classes that historically offer higher returns. In contrast, the Long/T-bill timing portfolio is long in REITs (although only at a 3.3% portfolio exposure) and Medium-term government bonds, and in T-bills for the other asset classes (given in the third row). Moving into these conservative investments during this market downturn not only prevented loss in the portfolio but actually increased returns, although not by much.


Pre- and Mid-Mortgage Meltdown
Let’s take a brief look at how these portfolios would have been allocated before and during the recent downturn.

Pre-meltdown (June, 2007):
Mid-meltdown (September, 2008):
Again, had you applied market timing to your portfolio, you would have been spared the nasty loss in stocks as you would have been 25% in Medium-term government bonds and the rest in T-bills.

What is the Analyzer recommending now?
If you’re wondering what the Analyzer is recommending now, here’s the up-to-date table for the market timing portfolio at the desired target of a 10% average annual compounded return:
Interestingly, you’d be long 25% in small-company stocks, 42% in Medium-term government bonds with the rest in T-bills (or under your mattress). We’ll see how these allocations change next month.

I hope you’re beginning to see how adding the concept of timing can save your portfolio from major damage through periods of market adversity, and how it can provide you with your desired return over an extended period of time while minimizing risk.

*Transactions costs, margin rates, trading fees, and taxes are not considered in these analyses as these factors differ with individual circumstances. The SMC Analyzer software, however, does have the capability to take all of these factors into its calculations.

Bye, Bye Buy and Hold; Hello Market Timing!

Tuesday, May 12th, 2009

The recent collapse in the financial markets was the final nail in the coffin for the traditional buy-and-hold strategy. Not only do I believe it, but so does virtually every talking head in the financial media—even Jim Cramer thinks it’s a trader’s market. To some, the term “trader’s market” conjures up java-jolted post-teens on their Wii stations buying and selling equities with a holding period measured in milliseconds. That’s day-trading to the max and not what is meant by a “trader’s market.”

The term is used by most to convey a holding period of days to months, or as long as current market conditions remain valid. On that point, I wondered how applying a market timing scheme to the tenets of Modern Portfolio Theory would affect portfolio risk and return.

To that end, I appealed to Professor Pat whom my readers may remember as contributing many articles to the Stock Market Cook Book last year on the topics of Modern Portfolio Theory (MPT) and Post-Modern Portfolio Theory (PMPT). Pat also wears another hat—that of ace website designer and expert programmer. Who better to tackle this problem?

And that he did. The result of which is the SMC Analyzer, a powerful tool that can be used not only for portfolio analysis but also for market research. Over the next couple of weeks I’ll be using the Analyzer to provide you with market insights that have never been published before, to the best of my knowledge.

Today I’m going to show you how a market timing scheme beats the pants off of the traditional strategy of buy-and-hold.

Bye-bye Buy-and-Hold
The past ten years in the market has been brutal on many retirement accounts where the concept of buy-and-hold reigns supreme. Witness the two nasty downturns in the S&P 500 (chart below). The bursting of the dot-com bubble in 2000 and the mortgage meltdown in 2007 both slashed market capitalizations roughly in half.

Where would that have left the investor? Let’s compare the damage it would have done on two portfolios where the assets are allocated according to MPT guidelines: one that employs a market timing scheme versus a buy-and-hold strategy.


Market timing criteria
In developing a market timing scheme, we found the Commodity Channel Index (CCI) to be an excellent timing oscillator. When the CCI turns positive, the market is trending up. When it turns negative, the market is trending down. (The Analyzer also has the capability of using the rate-of-change (ROC) and the moving average convergence/divergence (MACD) indicators as timing tools. I prefer the CCI because it tends to give the best results over a wide range of inputs.)

The Analyzer uses monthly data for each of these nine asset classes: Large-company stocks (e.g., the S&P 500), small-company stocks, long-term corporate bonds, long-term government bonds, medium-term government bonds, Treasury bills, Real-Estate Investment Trusts (REITs), international stocks, and international bonds.* A separate CCI indicator is computed for each asset class and the averaging period is re-optimized every month. (This is a computationally intensive process, by the way.) The result is that when the indicator is positive, the investor would be long the percentage of that asset class as determined by MPT; and if the indicator falls below zero, the investor has the choice of either shorting (if appropriate) or putting that portion of the portfolio into a risk-free asset such as T-bills.

There is only one user input to the MPT part of the asset allocation calculation: the desired average annual portfolio return. Needless to say, the higher the desired return, the greater the associated risk. Let’s take a look at how applying a market timing scheme to an MPT-generated portfolio compares with a buy-and-hold strategy.

Market timing kicks buy-and-hold butt!
The chart below compares a buy and hold portfolio with one using a market timing scheme we call Long/T-bills. That is, when the CCI indicator for that asset class is positive, we’re long in that class according to the portfolio percentage as calculated by MPT. When the CCI turns negative in that asset class, we move into T-bills according the percentage specified by MPT.

Let’s look at the case where we want an average annual 10% compounded return, and let’s see how we would have fared through the previous two market downturns.


Beginning in 1990 with a $1 in each portfolio, the one based on market timing did in fact give us close to the 10% desired return whereas the buy-and-hold portfolio only returned a measly 4.2%, not even half of what we wanted. Even more surprising is how much riskier a buy-and-hold strategy is compared with a timed one; the risk parameter, as measured by the standard deviation of actual returns, is more than double (15.8% compared with 6.9%). Wow!

What this graph is showing us is how very detrimental a major downturn can be to a buy-and-hold portfolio. The moral of this story is that it pays to cut your losses when they’re small before they get to be so large that it would take many, many years to get back to previous peak values.

I’m really glad my thesis paid off in the creation of the SMC Analyzer because now there’s an analytical tool to help us realize our portfolio goals at reduced risk. I believe this to be a major advance in asset allocation theory. Some of the results from the Analyzer are mind-blowing, especially seeing how different market strategies impact portfolio returns. We’ll be discussing these in upcoming blogs. These next few weeks will be exciting indeed!

For further reference:
To learn more about Modern Portfolio Theory, please refer to Professor Pat’s excellent articles found in the blog archives published on these dates: 4/21-24/08 and 6/2-3/08. You can also find out more in the SMC Analyzer Features Tour.

*In the Professional version of the Analyzer, users have the option of adding their own asset classes—a very nifty feature!

Aloha mai…Yang shok…Titambirei…Velkomin…WELCOME!

Sunday, May 10th, 2009

This is how folks from Hawaii, Tibet, Zimbabwe, and Iceland say welcome but no matter where you’re from, I want to extend a warm welcome to my current blog followers and to all of you newcomers to the new home of the Stock Market Cook Book. I’m very proud of it and am very excited about showing y’all around the new digs, but before I begin the tour I first need to thank Programmer Pat for designing and creating this entire site from scratch. The would simply not exist if it wasn’t for his considerable skill and expertise in putting it together. On top of that, he is also responsible for creating the SMC Analyzer which I’ll discuss shortly. Words cannot adequately express how deeply grateful I am for all of his efforts. Thank you, Pat!

Okay. Now we can begin the tour. Uh, don’t forget to wipe your feet on the welcome mat!

The Home Page
The main page is divided into three sections. On the right side of the page you’ll see a panel showing the current state of the market. Run your cursor over the Dow, Nasdaq, or S&P 500 headers and you’ll see the corresponding intra-day chart. Below the chart is a ticker of the thirty Dow Industrial stocks (we’ll see how long GM lasts on that list) followed by the top financial headlines. (Click on any headline to show the complete story.) Note that all of the above resources are updated every five minutes. Beneath the headlines box are a list of resources and blog archives.

The center of the page is the blog itself. To see more blog entries or if you want to leave a comment, click on the “Leave a comment or view previous posts” link at the bottom and you’ll be redirected to the blog section.

The left side of the page is where you’ll find a list of our products which include investment strategies or “recipes,” and a portfolio analyzer. As much as Dr. Kris loves researching her articles and sharing her financial knowledge, she’s also interested in getting compensated for her hard work. The good news is that she’s sprucing up her recipes and adding more content to them—hey, for the price of a couple of frappucinos, you can have your own Calendar Call Cake and eat it, too! For now, only four out of the seventeen listed recipes are available but more will be rolled-out shortly.

The other product is the one I’m most excited about—the SMC Analyzer. We’ll be talking more about it over the next couple of weeks. Briefly, it’s a powerful tool that combines market timing with modern portfolio theory—something that I don’t think has ever been done before, and believe me, it wasn’t an easy task! What the analyzer tells you is how much of your portfolio you should allocate to specific asset classes to attain your desired level of return. The beauty of this system is that you only need to rebalance your portfolio once a month at most. This system is far superior to the old buy-and-hold strategy as substantially greater returns can be realized while assuming the same risk. The Analyzer is a tool for investors, not day-traders. It’s particularly useful in managing retirement accounts. Professional money managers will also find this to be an indispensable tool in portfolio balancing.

The SMC Analyzer is a powerful product, but not everyone will find a need to utilize all of the features. With that in mind, we created two versions: a professional version that includes all of the bells and whistles, and a pared down personal version that is easier to use while still giving accurate results. For a more detailed description, click on the Features Tour or click on the Analyzer Demo and check it out for yourself.

Well, that’s it for now. Hope you enjoy the new site. It’s still a work in progress and if you have any technical problems, questions, or comments, we’d appreciate your feedback. You can write us at either of the following addresses:

Tomorrow we return to our regularly scheduled programming. Stay tuned!

New website coming Monday!

Thursday, May 7th, 2009


Dr. Kris, the founder of the financial blog StockMarketCookBook, today announced that her blog will be moving to her new website this coming Monday, May 11th. Besides her (almost) daily insights into current market trends, she will be introducing new and exciting financial products designed for both personal and professional use. More information on these will be provided as Monday approaches…