Since 1830, laws in The United States have relied on the principle that a prudent investor must act like other prudent investors managing similar portfolios with similar investment objectives. In other words professional money managers cannot do whatever they want when taking care of other people's money.
The definition of a prudent investor has undergone major changes during the past century. In simple language, the prudent investor rule describes the standards to which managers must adhere when investing money for their clients.
One hundred years ago, no manager would have considered investing other people's money in the stock market. Before 1945, prudent investment professionals, and the law governing their liabilities, condemned stock investing as imprudent speculation. Later, as inflation became part of our everyday lives and the legal view of stock investing changed, stocks became the core holding of most investment portfolios.
In modern times, as it became apparent that few investment professionals could outperform the stock market (as measured by comparing their performance with that of broad based indexes such as the S&P 500 index), the law came to
accept passive investing, or indexing, as a prudent strategy. Advisors were no
longer required to diligently search for outstanding investment opportunities.
This simplified road to investing became the norm. Money managers were now pleased when they matched the returns of their peers.
As the market soared during the 80's and 90's those 'average' returns were more than acceptable as the value of the average investor’s portfolio grew. When the bubble burst, and the markets declined, average returns became negative and once more became undesirable. That’s when people noticed that hedge funds were outperforming the market. Although these funds keep their trading strategies secret, it's known that they take advantage of options to find investment opportunities that are not available to traditional money managers.
Some of these superior returns by the hedge funds are due to their ability to use leverage. That means they can borrow money (use margin) to increase the size of their investment portfolios. But a significant part of their profitability comes from their use of derivative products, including options. Now that there is fear of recession and the potential for markets to fall yet again, the appeal of hedge funds and their ability to adopt conservative option strategies, such as those described in the Rookies Guide to Options are attracting a greater number of prudent investors.
As today's hedging strategies become more
and more accepted, will they become the new standard for the prudent investor? Is that a possibility – that the versatile stock option can become the investment tool of choice for risk adverse investors? Only time will tell, but I believe that’s the direction in which we are headed. It’s reasonable to anticipate that using options will eventually be widely accepted as an acceptable investment tool for the prudent investor.
Isn’t it time you learned to use options to reduce risk and enhance returns?
Original version first appeared in the February 2004 edition SFO Magazine.
Download my eBook – an abbreviated version of The Rookies Guide to Options.