The Importance of Smoothing Out The Ride


Gil Reich from Seeking Alpha interviewed Michael Kitces from Nerd's Eye View, it was a great read. Kitces said "good advisors tend to be middle of the road…when markets are going up, we trail the market." He then went in a slightly different direction but I want to focus on smoothing out the ride over the course of an entire market cycle. While I have been writing about this concept since the earliest days of the blog, this link from 2010 provides some good color.

In that link I talk about the so called 75/50 portfolio, a concept that John Serrapere wrote about a few times for what used to be Index Universe (now I haven't seen anything from John in many years, I knew him a little bit in the 1990's, he was one of our clients when I worked in Schwab Institutional. The idea behind 75/50 is to capture 75% of the upside with only 50% of the downside. Depending on the sequence of returns, 75/50 has a good chance of outperforming over a multi-year periods on a risk adjusted basis and even on a nominal basis. It is not infallible, nothing is, but as a concept, would you be willing to only get 90% of the upside with less downside, like maybe 60%? Stick any numbers you want into that question. If that appeals to you, then you have at least some interest in smoothing out your ride.

The chart tracks CBOE Buywrite Index (BXM), CBOE 2% Out of the Money Buywrite Index (BXY) and the S&P 500 for a ten year period. BXM offers a smoother ride to the same result which means outperforming declines and lagging the rallies. BXY also outperformed on a nominal basis. I am less confident that BXY's outperformance could be repeated (being that far of the SPX in ten years) but I do believe the concept underlying both can show a very favorable risk adjusted result over the next ten years. Going on this path requires patience as the expectation needs to be that these indexes, as well as 75/50 or something else that purports to smooth out the ride would likely lag behind years that the index is up a lot.

This is a valid approach but not right for everyone, as no strategy is right for everyone. Like any other approach, there are drawbacks and in this case they are pretty easily defined. If this doesn't appeal to you, then there is some other strategy that does, it will have periods that it struggles, all the better if you know ahead of time when it is likely to struggle. The bigger takeaway is to not become impatient during the inevitable periods where what you think is the best possible way to reach your financial goals struggles. Success with investing is about patience, not six-12 month performance periods.