Opinion: Financial Advisors Ignore Options

Investors everywhere want to know what happened to the value of their portfolios and especially, what could have been done to prevent such damage.  IMHO, the answer is easy:  Hedge – reduce the risk of owning – a portfolio by adopting conservative option strategies.

I've been preaching the use of these option strategies for years, but nobody wants to think about hedging when the markets are rising.  Thus, too few investors have the knowledge to take advantage of these methods when they are needed – in extremely volatile markets.


Options Have a Bad Reputation

Many hypesters promote options as the path to quick riches, and that nonsense helps give options a bad name. 

The recent market massacre has been (at least partially) blamed on derivatives (options are a derivative) such as mortgage-related SWAPS. 

Options simply have a bad reputation and the only way for that to be overcome is for options to generate some favorable publicity.


Traditional Advice on Risk Management

The
traditional advice from professional
financial planners is to 'diversify' and 'don't panic.'  For some
reason, alternative ideas are seldom offered.  Recently another suggestion has been heard: This piece of advice was offered  by Jim Cramer on the Today show, as he told viewers
not use the stock market for money they are going to need over the next few years, and to get that money out of the market immediately.

My question is:  Why are advisors telling people about unloading  now –
where was this advice when the Dow Jones Industrial Average was above
14,000?  I know the answer:  When
the markets are going higher, no one wants to talk about not being fully invested.  Advisors only offer the idea of
being certain that short-term cash is available, after a debacle.  Note Cramer's recently issued a 'get out' warning when the DJIA had fallen to 8600
.


Financial Journalists

There are many excellent financial journalists.  They take their work seriously and it's their job to provide good, time-tested advice for their readers.  They cannot get involved with offering bad, or controversial, advice.  Thus, a great deal of judgment is required when deciding how to help the individual investor.  The safest path is to quote professional financial planners, stockbrokers, or perhaps TV's talking heads.  And when interviewed, those people  never talk about options.

Many financial planners are decades behind the times and are unwilling, or unable, to offer new ideas to their clients.  Interviewing long-time professionals and passing on their advice seems reasonable.  But, the professionals must be knowledgeable.  All I hear from them is 'diversify' and 'stay the course.'


A Blogger's Idea

Here's one good suggestion from the Roseman Eruptions blog: 

"Hedge funds are supposed to “hedge,” but
instead were mostly “leveraged” like hell and have been slaughtered
since July. I’m not sure what these hedge funds are doing but it’s
certainly not hedging. Many deserve to close and many will.

As we move forward, investors must learn how to hedge their
portfolios to protect against the next financial crisis or possibly,
the next phase of this bear market. That means using reverse index ETFs [increase in value when market declines and vice versa]
to cover your stock market exposure. This is a simple, cost-effective
and liquid strategy that can protect your investments in a bear market.

For example, if you own stocks you truly don’t want to sell (tax
reasons, great dividends, strong franchises, low prices, etc) then at
least cover your exposure to neutralize your risk. Why mutual funds and
hedge funds don’t do this I’ll never understand.

Let’s suppose a portfolio has $100,000 invested in stocks; I suggest
the same amount should be invested in reverse ETFs. At the very least,
a one-for-one hedge should leave you flat or almost unchanged in a big
market decline or rally."


This blogger is not in the mainstream media, and his thinking adds a different idea into the mix of 'what's an investor to do?'  I wish ideas like this could be shared with a wider audience.  I don't love this specific idea, but it does have merit and can be used to hedge part of an investor's portfolio. The idea of trying to completely offset losses by holding an equal amount of reverse ETFS surely cancels all gains.  There's no point in doing that.

This blogger's idea of owning a mix of investments some long and some short – represents a big improvement over traditional advice.  But there is correlation risk.  Imagine if your shorts rose while your longs declined!

Amended much later: Being long and short simultaneously is an absurd choice.  Why pay management fees?  If you want to be 'flat' the market, sell your holdings.  Or sell a portion.


Options

IMHO, hedging with options was – and remains – the best method for protecting an investment portfolio – while still allowing the investor to earn significant profits.

When will adopting conservative, risk-reducing, option strategies become common among individual investors – the people who can really benefit by using them?  Not until more investors hear something positive about option strategies.  Or financial journalists are willing to encourage their readers to consider learning about options.  After all, options are not for everyone.  But education ought to be.

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One Response to Opinion: Financial Advisors Ignore Options

  1. Peter 10/28/2008 at 7:21 PM #

    Hi Mark,
    great post – keep up the good work! PS – I just recieved your book, and now I am looking forward to reading it…
    Peter.