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Can You Beat the Market?


Passive investing could be your path to success.

Editor's Note: This is Part 1 in a multiple-part series. Part 2 can be found here, Part 3 can be found here, Part 4 can be found here, and Part 5 can be found here.

Investors want to beat the market and continue the search for alpha (a coefficient that measures risk-adjusted performance based on the specific security and not the entire market). Professional money managers of mutual funds and hedge funds are paid big bucks to find alpha and deliver enhanced performance to their investors. But most are unable to beat the market on a consistent basis, and the search for alpha remains elusive.

There are those who think that actively trading in an effort to find that alpha is misguided, and it's better to invest passively (thereby saving money on trading costs, management salaries, and bonuses) by owning shares of index funds or ETFs. Those funds charge very low management fees.

It's not my purpose to continue the debate over passive vs. active money management, but along the way I'll mention some studies that have been made.

Are there other ways to enhance market performance? Can we use option-based methods to produce the equivalent of alpha? That's the basis for this series of posts.

In August, one blogger wrote that "MW has been popping up in the comments sections of a lot of blogs recently touting an options collar strategy." I wouldn't mention this if I weren't that 'MW'.

It's true. I've been entering into discussions, where I feel it's appropriate, suggesting that personal finance bloggers give more support to the idea of using collars as a conservative investment strategy.

Here's the background: Most personal finance bloggers take the position that active investing is inferior to passive investing. The data supports their stance.

In other words, most mutual funds can't match the performance of the appropriate benchmark (S&P 500 Index is the most commonly used benchmark).

Why can't those funds, operated and managed by professional money managers, beat the market?

The bottom line is that they can, on average, match the market. But, it's been shown that the costs associated with active trading, plus the management fees, are high enough to convert the average fund from a market matcher to an under-performer.

Sadly, most of the investing public is unaware of such studies. In addition, there are many salesmen (earning hefty commissions) for those actively managed mutual funds. Thus, most individual investors have no reasonable method for learning about the benefits of buying shares of index funds instead of actively managed funds.

The information is widely available, but most people trust their brokers and advisers, ignoring that free information.

Studies have also shown that individual investors have a higher opinion of their performance than their performance actually deserves. Along the same lines, those who believe they're doing well tend to trade more frequently. Additional data shows that those who trade the most underperformed the most.

Thus, not only is passive investing more likely to produce a better result for professionals, but the same is true for individuals. Less frequent trading of stocks yields better results.

The bottom line is that personal finance bloggers, who tend to be conservative and frugal, favor passive investing.

With that in mind, I entered the conversation on several blogs, suggesting that owning option collars (buy stock, buy puts, sell calls) represents a conservative strategy that's guaranteed to minimize losses. The trade-off is that profits are also limited, and that's a big turn-off for investors who believe it's easy to out-perform the markets.

Thus, one of my responsibilities when promoting the use of collars is being able to demonstrate that they produce reasonable returns and are not cost prohibitive. That's now possible.

Our path will include covered-call writing as a method of enhancing stock market returns. It may not strictly count as alpha, but the cash earned is just as spendable.
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No positions in stocks mentioned.

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