Most investors are familiar with the hackneyed phrase, “past performance is no guarantee of future performance.” That’s the “cover your backside” sentence that professional advisors put in their recommendation advisories. They do that because they spend a lot of time talking about the past, and trying to figure out from the past what is going to happen in the future.
But in fact it’s only the future that an investor is interested in, not the past. And, to put it more bluntly, looking at the past is not a very good methodology for predicting the future. Investment indicia are constantly changing, and as the ancient Greek philosopher once said, “you can’t dip your toe into the same river twice.”
Of course, no one wants to take investment advice from Greeks right now.
Many investors have become weary of trying to predict the future at all, and just put their money into bonds to receive a fixed, predictable return. That used to be a pretty good strategy from a psychological point of view: no risk, no worry. But with interest rates well below inflation, as Warren Buffet recently wrote, an investment in bonds today is a guaranteed way to lose money over time. And Warren had something similar to say about gold: if you buy a gold brick now and hold it for 10 years, at the end of the 10 years all you have is the same gold brick. Your only hope for a profit is that some bigger fool thinks it’s worth more.
Others put their investment dollars into the S&P index, known at the SPY. That gives them the same up or down performance as the stock market in general because it’s a basket of 500 of the leading public stocks. Some commentators claim that this investment has, historically, out-performed most of the expensive investment advisors that are picking individual stocks. The only problem with it is that you never know how much investment dollars you will have from time to time, because you never know if the market will go up or down.
Because of that uncertainly, some investors opt to forget the market and put their money into income producing real estate. One reason to do that is because, absent major vacancies, real estate produces a pretty stable source of income, and while the underlying value might go up or down, the income can stay pretty much the same. And over time, real estate does tend to protect against inflation.
That’s a good argument, but the downside of investing most of your investment capital into real estate is that it’s not liquid. And just when you need another $50,000 or so for a payment on college tuition is when the real estate market is down and you don’t want to sell — or interest rates are way up and you don’t want to refinance.
So I take a middle ground. I keep liquid by investing in the market, but I use the assets that I purchase to produce a stable income, and I do not depend primarily on the sale of appreciated stocks to generate my profits. I do this by writing options.
There are two kinds of options that I write to achieve this goal. One is the sale of covered calls. I look for a company that is fairly stable in a market that is stable, and has public stock that pays a dividend to hedge against inflation. An example of this is Proctor & Gamble (PG). Over the past year the stock has moved up and down between $58 to $68 a share, somewhat more change than one would like, but not bad considering the extremes of the market during that time period.
At the moment the stock is in the middle of that range, about $64. It pays a dividend equal to a 3.5 percent yield, probably better than the current rate of inflation. It’s in a stable market — consumer goods — and it sells both in the U.S. and internationally, which is a good diversification for stability.
So I buy 1,000 shares for $64,000 (or less, depending on cash on hand). At the same time I sell 10 calls. There are a lot of potential calls I can sell. I want to select the earliest date that will give me a reasonable premium since the sooner I earn the money the less risk I have, but a strike price (the price I agree to sell at) that is enough above my cost to show an additional profit.
In this case I select the October $67.50 calls. That’s further out than I prefer to go, but I need to give the buyer that much time in order to receive almost $1 in premium, for a total of a bit under $1,000.
The net result of this is that I own the stock and receive a nice dividend. Someone pays me $1,000 (and I can do that twice a year, for a total of $2,000 a year — an additional 3 percent or so on my investment), and nothing special happens unless the stock goes up to $67.50 and is purchased from me. And I don’t mind selling it at that price over the next five months and taking that nice profit. Meanwhile, I’ve raised my return from 3.5 to 6.5 percent.
The other strategy I follow on a regular basis is to sell what are called “put spreads.” For example, I have believed for some time that Apple stock will not drop below 10 percent in any three month period. So I sell a put at about 10 percent below current market value. The “put” is a contract under which I agree to buy the stock if it drops below the “strike price” we agree upon. In exchange for my agreement, I am paid a premium, which in this case on 10 puts can be quite large, around $8,000.
But I don’t want to take the risk of buying 1,000 shares of Apple stock, even if it drops, because it’s too expensive and would require too much of my capital. So to protect myself I buy a protective position 10 points below the sales position, and pay out about $6,500. Now I have a potential profit of $1,500 on these two positions, but my potential loss in the worst case, if the stock drops about 15 percent in the next three months, is only $10,000 ($1,000 per point) less the $1,500 I received, or a net $8,500. This is an amount that I could afford to lose in a bad scenario.
But there are ways to even avoid that loss if things go poorly. And in my next column I will give some examples of this strategy, because I realize people find it complicated, and will explain the additional methodologies available to recover from the unlikely case where the put spread ends up in a loss.
For information about Merv Hecht and more details on the strategies and stocks he writes about in this column, visit his website at DoubleYourYield.com.