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Options 101: The Prudent Investor


Options are the shrewd professionals' tool of choice.

Editor's note: Original version first appeared in the February 2004 edition of SFO Magazine.

Professional money managers cannot do whatever they want when taking care of other people's money. Since 1830, laws in the US have relied on the principle that a prudent money manager must act like other prudent investors who manage similar portfolios with similar investment objectives.

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, and seeking to outperform was not worth the risk of underperforming.

As the market soared during the 80s and 90s, 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 most take advantage of options to find investment opportunities that aren't available to traditional money managers.

Some of these superior returns by the hedge funds were due to their ability to use leverage. That means they can borrow money (use margin) to increase the size of their investment portfolios. But leverage isn't their only tool, and a significant part of their profitability comes from their use of derivative products - including options.

Again, times are changing. A severe recession is in progress and many hedge funds found that using too much leverage resulted in getting squeezed. Today, many hedge funds have lost money and gone out of business. But the idea of hedging portfolios by adopting conservative option strategies -- such as those described in The Rookie's Guide to Options -- are attracting a greater number of prudent investors.

As today's hedging strategies become accepted by more and more individual investors, will they become the new standard for the prudent investor? Will financial planners and finacial advisors learn to recommend such methods for their clients? Can you imagine: The versatile stock option, scorned for years by professional advisors and stockbrokers, becoming the investment tool of choice for risk-adverse investors?

Only time will tell. But I believe that's the direction we're headed, and that it's reasonable to anticipate that using options will eventually be widely accepted as a wise investment choice for the prudent investor.

Isn't it time you learned to use options to reduce risk and enhance returns?

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No position in stocks mentioned.

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