Hi. This is Michael Gross, co-author of McGraw-Hill’s “The Complete Guide to Option Selling” and also director of research here at OptionSellers.com. I’m here with your bi-monthly video lesson. The topic of this month’s lesson is “Real Diversification” and we’re going to go off the grid a little bit here this week and talk about something that’s on the minds of just about anybody that has accumulated or preserved a certain degree of wealth.
High-net-worth investors are always talking about diversification but when it comes down to really doing it, sometimes a lot of them probably aren’t as diversified as they think.
CNBC.com recently ran an article entitled “The Five Biggest Mistakes Made by High Net-worth Investors.” Do you know what the number one mistake was? Lack of diversification.
We’re so programmed to put our funds into traditional investments like stocks, bonds, and real estate that we forget that even with a mix of those asset classes, certain events could affect all three and cause a real drawdown in our portfolios. One of the goals of diversification is to help smooth that equity curve out and help give us a more steadily growing portfolio that’s not as vulnerable to the sharp whims of the market – whether that be stocks, real estate, bonds or all three, like we saw in 2008.
Before we get started, if you’re interested in selling options an option premium, we do recommend “The Complete Guide to Option Selling
”. It’s now out and its third edition and you can get it on our web site www.optionsellers.com/book.
As a high net-worth investor, when we think about diversifying our portfolios we’re often thinking about, “Well, what else can I put my money in? What else can I put it in it’s likely to appreciate?” And one thing I think a lot of investors of our class overlook is, it’s not just diversification of asset class, its diversification of strategy
. And that second part is one thing a lot of high-net-worth investors overlook.
So one of the key concepts of this video is, if we want to get truly diversified where we’re both growing and
preserving our wealth through a number of different things and ways, we want to be diversified in asset class and we also want to be diversified in strategy. And what you’ll find is most alternative investments offer one or the other but very few offer both.
So we’re going to look at some of the most popular asset classes today what they might be able to do for you and talk about some of their drawbacks as well. This is the key concept that we want to look at. Do they offer this? Do they offer this or do they offer both?
When high net-worth investors think of alternative investments. What are some of the first things they think of? Well, we have tangible hard items like – we can buy art, coins, and, everybody’s favorite, we can buy real estate.
Now these can be great investments. They can be great alternative investments. They can be great ways to grow wealth, especially if you know what you’re doing in doing them. But they have one drawback. And that is, you’re buying these hoping that their value will appreciate and if they do great you do very well. I know many people build wealth through real estate and there are some of these other things. There’s nothing wrong with that, but the drawback to it is if we enter into some type of deflationary period, these could actually decrease in value like we saw in the real estate crash in 2009. The same goes for arts, coins or any type of hard asset.
When you’re buying for asset appreciation, you need the value of that thing to go up to make money. So while you’re in a diversified asset class here, you’re not really diversified in strategy because you’re relying on the same thing you are in the stock market. You buy stock, you want it to increase in value. So you are diversified asset class not diversified and strategy.
Let’s look at another alternative. And, again, I’m not saying these are bad investments. We’re simply looking at the differences between alternatives and what they offer and what their drawbacks are.
What’s the second way investors tend to try and diversify their holdings? Number two is a Hedge Fund. “Well, I’ll just buy hedge fund and that’ll be it. I’ll be diversified.
” Well, first of all, there are many different types of hedge funds and many different types of strategies that they use.
One thing I think would be a surprise to a lot of individual investors is a lot of hedge fund managers are only trying to do what individual investors do, but do it better. In other words, they’re trying to pick the right stock to buy. They are trying to pick the best real estate investment trust. Or they’re trying to pick the best commodity to buy or sell. But you’re still not getting that diversification of strategy. I encourage a lot of people to take a hedge funds performance and compare it to the actual performance of the stock market and see how far it differs. Hedge funds – yes – there are some that can offer you both diversification of strategy and asset class. I think you will find very few that can offer you both. Let’s go to number three.
When people say, “Well, I’m diversified. I short stocks. I know how to short stocks. When I think there’s a downturn coming up, I short the S&P or I short my shares of Apple or what have you.
” Well, that’s great. That’s a diversified strategy. But the problem with that is, obviously one is, you’re picking direction. But diversified strategy nonetheless. The obvious drawback of course is you’re not diversified in asset class. You’re still trying to short your equities. Now, that can be a good thing if you have a bunch of long positions. But not if you’re looking around for some diversification in something that’s going to be unaffected by big swings in the stock market. Either way, short selling probably isn’t going to qualify for that because you’re not getting diversification of asset class.
Let’s go to number four.
Number four is Stock Option Selling. Now, this can be a great way to go for a lot of investors that have taken a step up in sophistication and they’re looking for a high odds strategy. They’re looking to generate more income off their stocks. I talk to a lot of investors that have started out in stock options selling, and I have nothing bad to say about. It’s a great strategy. And if you’re watching this and you do it well, you know what I’m talking about. It can be a boon to your portfolio.
But we’re talking about diversification in this video.
You’re still in the stock market, OK? A big move comes along and equities prices can be affected here. Now, maybe you’re on the right side of that. But long story short, you’re still not diversified in asset class. You’re diversified in strategy now, but not asset class. Let’s go to number five.
Commodities: “Well, I’ll get diversified and I’ll go into commodities.
” Are you diversified in asset class? Absolutely. You’re not in stocks anymore – not real estate, but what’s the problem with commodities?
Well, we can almost go back to number one where you’re buying hard assets. Most investors, when they go into commodities, what do they do? “Well, I’m going to buy commodity index,” or “I’m going to buy into a commodities fund,” or “I see Vanguard offers a commodities fund. I’ll do that. I think commodities are going to do well this year.”
Well, okay that’s all fine. You diversified in asset class. But we’re back to where we were with the coins and the real estate. You’re buying a hard asset class and you’re hoping that it appreciates in value. So, you’re diversified in asset, but you’re not diversified in strategy. You’re still buying for appreciation.
So now, let’s get to the strategy that can offer you both of these things. If you sell commodity options – either now or you’re considering doing it in the future – it has its drawbacks. You have to get used to the leverage. If you don’t know what you’re doing, you can lose money. Even if you do know what you’re doing, you can lose money. But selling commodity options – one of the things that makes it unique is it offers the two things we talked about: you get diversification of asset class and you get diversification of strategy.
What does this do for you? It gives you a portfolio that is more or less uncorrelated to anything else on the board. And when I say uncorrelated, I mean it’s even uncorrelated to the outright direction of commodities prices.
Why is that? Well, because you can sell options on either side of the market. So it’s not going to correlate to equities performance; not going to correlate the bonds; not going to correlate to interest rates. Those things can affect it but it’s not going to correlate to them. It’s not going to correlate to what real estate prices are doing.
And one thing you will find in a commodity option portfolio that is unique – unlike a lot of other types of portfolios like a stock portfolio – diversification within the portfolio.
For instance, your positions will all be somewhat uncorrelated to each other. Whereas, if you have a stock portfolio and you have shares of Apple, shares of Exxon and shares of Disney, if the entire index takes a dive, well guess what? It doesn’t matter how good those stocks are, what the fundamentals are, or what the stochastic says. They’re probably all going to go down at once.
When you’re in a commodity option selling portfolio, not only are you selling options in a group of different commodities, many of them are going to be somewhat uncorrelated. For instance, the price of silver has little to do with the price of natural gas. The price of corn will have little to do with the price of coffee. You’re selling options in at strikes which can be above the market or below the market. So, you have a portfolio that doesn’t correlate to anything and you have positions that are somewhat uncorrelated to each other. That’s one way you can get real diversification. That’s your goal in preserving your wealth.
Commodity option selling can have a role in that type of portfolio. Now, obviously, you have to be comfortable with the risk and you have to be comfortable with what you’re doing. And, that’s all another aspect of learning about this strategy. But for pure diversification purposes, if that’s the only reason you consider a commodity option selling portfolio, it’s probably a good one.
I hope you enjoyed this week’s lesson. And, if you’re interested in learning more about selling commodity options with us through a managed option selling portfolio in our private client group, I recommend our investor discovery kit. It comes with a full package that explains to you all of the programs we have available and also comes with a 30 minute DVD of James Cordier’s seminar to high-net-worth investors. I hope you enjoyed this week’s lesson and will talk to you again in two weeks. At that time, I’ll be back with a more traditional type lesson on how to apply the strategy.
Thanks and have a great month.