Level 1 – The Basic Investment Portfolio
Investing in stocks and bonds can be scary. While it is one of the best ways to grow your nest egg, the risk of a sudden loss of value can throw your financial plans into disarray. On the other hand, not investing in risk-bearing assets (such as stocks and bonds) can also leave you behind, with inflation eating away at your savings. While you can’t make market volatility go away, there is a way to gain exposure to markets while also limiting the risk of your investments losing value.
First, picking individual stocks or timing equity markets is extremely difficult. Even most professional fund managers struggle with both. Buying and holding a balanced portfolio of assets and periodically rebalancing has proven to be the most efficient approach for most investors. This is commonly referred to as a “gone fishing” portfolio (there is a great book describing this method in detail – The Gone Fishing Portfolio). The typical balanced portfolio consists of a combination of stocks and bonds broken down into different allocations:
- Domestic & Foreign Stocks
- Growth & Value Stocks
- Small & Large Company Stocks
- Federal Government Bonds, Municipal Bonds, & Corporate Bonds
- Commodities & Commodity Producers (including oil, gold, metals, etc.)
At any given time one or more of these categories of investments will outperform the others. Usually, these periods of outperformance are followed by periods of underperformance in those same categories. For example, growth company stocks soared from April 2020 through late 2021, but then growth company stocks dropped the most in early 2022 while commodities soared. By periodically rebalancing the mix to the prescribed allocation, you gain the additional returns that this cycle generates while also managing risk by preventing overexposure to a single asset category. If you only rebalance once a year, then your gains may also be subject to a lower tax rate.
This investment approach is the core concept of most managed portfolios, and at Amplified Alpha, we also rely upon its benefits as a baseline starting point for each investor’s unique strategy. What differs in our approach is our analysis of past theoretical performance in order to establish clear return and risk thresholds, along with tax-efficiency.
Level 2 - Risk Management
The downside of the basic portfolio approach is that it goes through boom-and-bust cycles, regardless of the mix of investments (the dot-com bubble, the Financial Crisis, COVID lockdowns, etc.). However, there are tools available to manage the risk of large losses, the most common and accessible of which is stock options. A stock option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date.
The simplest form of risk management via options is the purchase of long-term puts. Here is an example of how a put can help manage risk:
Day 1:
- Buy 100 shares of SPY (an Exchange Traded Fund, or ETF) for $400 each (or a total investment of $40,000) in order to have exposure to the stocks of the S&P 500 Index.
- Buy one SPY put, expiring in two years, at a “strike” price of $400, for about $4,000.
Two Years Later:
- If in two years the price of SPY is $300, your value lost $100 a share, or $10,000. However, the put gives you the right to “put” (or sell) 100 shares of SPY stock for $400 each. In reality, you would not transfer the stock to the person that sold you the put, but instead you would cash in your put for $10,000, offsetting your loss in SPY. This does not mean you did not lose any money – you lost the “premium” you paid for the put, or $4,000, but that's still better than losing $10,000!
- If in two years the price of SPY is $500, you gain $100 a share, or a total gain of $10,000. Since the put you purchased is “out of the money,” meaning its strike price is below the current price for SPY, your put expires worthless and you lose the $4,000 premium you paid for it. You still gain $6,000 in total, and you had a lot less risk of loss for the 2-year period due to the “insurance” provided by the put.
Note that if two months into this two-year period SPY were to drop to $200 a share, your account would appear to have lost almost $20,000, even though you have a protective put in place to prevent this loss. The reason is timing. The put has a two-year lifespan prior to its expiration date, and while in the interim its value at two months would go up, it would not go up to $20,000 immediately because it has 22 months left until expiration. Since there's a chance SPY would recover its value during the 22-month period, no one would pay $20,000 for the put at the two-month point in its term. However, if SPY stayed at $200 a share throughout the two-year period, you would see the value of your put go up over time until it reaches $20,000 at expiration. You would have protection from ultimate losses, but not much protection from interim period volatility. It’s best to be 100% certain you won’t have to cash in prior to options providing the full protection they reach upon their expiration date.
There are many different variations on this scenario (the specifics of which are too detailed to cover here) that may include put spreads, covered calls, and other options strategies. The bottom line is that, judiciously used, options can reduce your risk while increasing your investment returns.
Level 3 – Risk Management and Leverage
Exchange Traded Funds and Exchange Traded Notes (ETFs and ETNs) are types of funds that share certain characteristics with mutual funds and stocks. You should research the risks and benefits of these instruments fully prior to investing in them. While most ETF/ETNs attempt to follow a specific index or set of stocks or commodities, there are also versions that attempt to generate a multiple of a specific index. For example, SPY mimics the S&P 500 large cap stock index, but UPRO mimics three times the daily performance of the S&P 500 index.
Leveraged ETFs involve significant risk well beyond just the multiple of the underlying benchmark they follow, including but not limited to counterparty risks, leveraged asset decay, and illiquidity. They are not intended to be bought and held for extended time periods, or as a core investment in one’s portfolio. However, judiciously used, they can provide added exposure (to both gains and losses!) while freeing up cash for other applications within your portfolio. Through our backtesting of these investments, we believe we can successfully combine the use of leveraged ETF/ETNs, the use of options, and the balanced portfolio strategy to achieve:
- Lower Overall Risk
- Greater Overall Returns
This is Amplified Alpha’s most common portfolio approach: to use the risk management power of options, along with judicious use of leveraged ETF/ETNs, to allow you to over-expose* your portfolio to risk and potential gains, while also mitigating long-term risks. The level of risk and reward is unique to each investor. Based upon historical data analysis (we back-test our portfolios through at least a 25-year period), we can set the relative risk level desired by an investor and estimate the performance their portfolio should produce (relative to future stock/bond market performance). Our analysis indicates that we can achieve up to a 60% reduction in risk relative, or up to 60% greater return at the same risk, compared to traditional approaches.
*Over-Exposure
Our preferred approach to achieve “over-exposure” to stocks is to use traditional index ETF investments, combined with protective options strategies, in a higher percentage than in a typical portfolio, along with limited amounts of leveraged ETFs and ETNs. Due to the significant complexity of the risks involved, we calculate the relative risk and reward through our 25+ year backtest prior to determining the best mix for your portfolio.
It’s also important to note the time period for which a risk management/leveraged portfolio is set up. The risk management is set up to deliver protection AT A SPECIFIC TIME IN THE FUTURE, not on a short-term basis. As such, only money that you know you will not need to access during that set time period should be invested in a risk management portfolio (typically 2 to 5 years). Needing to withdraw cash at an interim time can result in significantly amplified risk of loss. We can develop a strategy for you regardless of your time horizon, but the further out it is, the more innovative we can be.