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.