Swedroe: As Bad A Strategy I Can Think Of

One of my favorite films is “Moonstruck.” It contains a great scene—one I often use when discussing investment strategies I’m asked to review in my role as the director of research for The BAM ALLIANCE, because it makes an excellent and pointed observation.

In the scene, Cosmo Castorini, a plumber, explains to a young couple why he only uses copper pipe. He says: “Aluminum is garbage. There’s bronze, which is pretty good unless something goes wrong. But something always goes wrong.”

Recently, I came across a case involving an investor who had been impressed with a presentation by a certain investment firm. The firm recommended a strategy that included selling out-of-the-money puts on about 15 carefully selected “safe” stocks. He was told the strategy was “reasonably conservative” and would provide a return of 4 to 6 percent a year after a fee of 1.25 percent.

Before analyzing the strategy, it’s important to point out that this particular investor is a high net worth individual nearing retirement. He maintains a conservative portfolio with an equity allocation of just 30 percent. He also has little to no need to take risk because his marginal utility of wealth is very low. Despite these facts, he was intrigued by the sales pitch.

The firm launched its pitch by explaining it was extremely good at stock picking and only sold puts on the safest of companies—the kind of stocks Benjamin Graham and David Dodd would buy.

And in the event a stock did drop below the exercise price, it would “double down” and write more puts, and then continue to do so if the stock persisted in dropping. From my perspective, this is about as bad a strategy I can think of for most investors. Let’s examine why.

Selling Insurance

Writing puts is essentially selling insurance against falling stock prices. The writer of the put earns a premium for taking the risk that the buyer will “put” the stock to him at the agreed-upon price, which will occur if the stock drops below the strike price.

This strategy can look good on paper because in most periods, and often for long periods (such as March 2009 through February 2015), the writer will collect the small premium. That returns a profit in a large majority of months, quarters or even years.

Then one day the “black swan” strikes and all the prior gains, and sometimes more, can be wiped out. This is what happened to investors who followed a strategy of writing naked puts in the crash of October 1987, in the Asian contagion of 1997-1998, in the bear market of 2000-2002 and in the financial crisis of 2008.

These infrequent, but huge, losses are why this strategy is referred to as “picking up pennies in front of a steam roller.” And if leverage is used, as some fund managers do in an effort to turn pennies into nickels, the strategy then becomes even riskier.

Hedge fund manager Victor Niederhoffer is probably the most famous example of a manager who blew up not one, but two hedge funds using the strategy. He lost hundreds of millions of dollars in investor funds in each case.

Short Memories

To me, it’s no surprise that we are again seeing this strategy becoming more widely touted. It’s been six years now without a severe drop in the market. And we’re talking about the kind of drop that obliterates a strategy built around selling puts.

Unfortunately, investors have very short memories, and investment managers can show six years of good results. So, back to our example: The investment manager in this case showed the investor returns earned by this strategy from January 2010 through September 2014.

During this period, the strategy posted only five losing months (August-September 2011 and October-December 2012), and no month experienced a loss of more than 1.53 percent. It’s almost too good to be true. And you know what they say about things that are too good to be true.

With that warning in mind, let’s examine the reasons investors should avoid selling puts.

Loss Aversion

First, most investors are risk averse—the pain of a loss is much greater than the joy received from an equal size gain. The larger the dollar amount involved, the more risk averse investors become.

And while selling out-of-the-money puts in theory should provide you with a profit, the profit is small relative to the size of the potential loss. In such a case, it’s not likely that a risk-averse investor would find the strategy attractive, regardless of what they thought the odds were.

Second, investments that can be expected to earn losses in bad times should have high expected returns as compensation for that risk. Loss aversion is the main explanation for why stocks have had such high real returns. The risks of owning them tend to appear in bad economic times, just when labor capital becomes riskier as well. Thus, investors demand a large premium for taking such risk.

Of course, the strategy of writing puts results in those risks showing up at the same time when your equity allocation is suffering large losses, compounding the damage. Thus, one should logically demand a large premium, not a small one, for writing puts.

On the other hand, the strategy will make money when equities are doing well. In other words, writing puts doesn’t mix well with the rest of your portfolio. In fact, the equity allocation of a portfolio should be set at a level low enough that, during a bear market, losses will not be so large as to cause the investor to lose sleep or, even worse, engage in panicked selling. But there’s a third related reason we need to cover.

Negative Skewness And Fat Tails

It’s been well-documented in the research that individual investors have a tendency to prefer investments exhibiting positive skewness. Positive skewness occurs when the values to the right of (greater than) the mean are fewer but farther from it than values to the left of the mean. This preference is evidenced by investors’ willingness to accept low—or even negative—expected returns when an asset exhibits positive skewness.

The classic example of positive skewness is a lottery ticket. Some examples of stocks that exhibit both positive skewness and poor returns are IPOs, “penny stocks,” stocks in bankruptcy, and small-cap growth stocks with low profitability and high investment.

Writing puts creates exactly the reverse distribution of potential returns—negative skewness—the type of skewness investors dislike. Negative skewness occurs when the values to the left of (less than) the mean are fewer but farther from it than values to the right of the mean.

For example, a return series of –30 percent, 5 percent, 10 percent and 15 percent has a mean of 0 percent. There’s only one return less than zero and three that are higher, but the one that’s negative is much farther from zero than the positive ones.

Compounding the problem of negative skewness is that writing puts also increases the kurtosis of the distribution of returns. Kurtosis measures the degree to which exceptional values, much larger or smaller than the average, occur more frequently (high kurtosis) or less frequently (low kurtosis) than in a normal (bell shaped) distribution.

High kurtosis results in exceptional values called “fat tails.” Writing puts leads to both negative skewness and excess kurtosis, creating the risk of extremely large losses, something most investors—and certainly risk-averse investors—seek to avoid.

The Unlikely Is Still Possible
There’s yet another consideration. Just as the preference of individual investors for “lottery ticket” investments drives up the price for securities with that distribution—making them poor investments for risk-neutral or risk-averse investors—it’s also possible another behavioral phenomenon is at work here that leads them to underweight the true probability of a negative event. And that can lead to out-of-the-money puts not earning a sufficient premium to compensate for the true risk.

In fact, that is exactly what Nassim Nicholas Taleb, the author of “Fooled by Randomness” and an ex-hedge fund manager, believes. His investment strategy was based on the simple and straightforward precept that investors always underestimate the chances of improbable, out-of-the-ordinary, events.

As a hedge fund manager, Taleb’s strategy was to purchase those very same deep, out-of-the-money options that the investor in our example was being advised to sell. Taleb knew that, most of the time, such options expire worthless.

That’s another reason he believes that investors like selling puts—most of the time you win, and investors like winning. He believes most investors wouldn’t have the discipline to buy the catastrophe insurance (buying the puts instead of selling them), because they couldn’t stand to lose money most of the time, and possibly for long periods. It takes quite a lot of discipline to wait for the occasional catastrophe to strike.

Taleb also believed that in a market crash, the puts he bought would result in a very large payoff, and he expected that the occasional large gain would more than compensate him for the regular, but small, losses.

Thus, instead of selling insurance, as the investor in our example was being advised to do, Taleb’s strategy was to buy insurance because he was convinced investors underestimated the likelihood of catastrophic events resulting in the puts being too cheap. Taleb also understood that stock returns are, in fact, fat tailed and negatively skewed.

There’s one other negative about the strategy that shouldn’t be overlooked: It is tax-inefficient because the premiums received will all be considered ordinary income.

Don’t Double Down

Finally, there’s one last point to cover about the strategy that was proposed to the investor in our example. The investment manager explained how they would “double down” if the stock was put to them, meaning that while they might immediately sell the stock, they would once again write another put.

This is the financial equivalent of betting on red again and again right after black has shown up on the roulette wheel. At some point, you’ll run into a streak of blacks long enough so that your losses exceed your ability to keep playing. You have to quit before red shows up again.

An extended bear market will have you keep eating losses on the strategy at the same time your equity holdings have suffered. And eventually you might exceed your tolerance for losses and be forced to quit before the market might eventually rally.

The bottom line is that in good times, the writers of those puts make money consistently and quietly. But when the inevitable bear market rears its ugly head, they experience massive losses, which are often greater than they have the tolerance for. And when an investor’s losses exceed their risk tolerance, even well-thought-out financial plans can end up in the trash heap of emotions.

In other words, a strategy of writing puts is likely to make you feel good for a while, when all is well. However, it can cause an entire plan to blow up when things go bad. And they will go bad.      

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.