The Big Picture For The Week Of February 17, 2008

On Friday we went to the Waipi'o Valley. It is up in the northeast corner of the island, you turn off the main road at Honoka'a (a very neat little town in its own right) and go another nine miles.

You have to hike in and out. The hill is short, about 3/4 of a mile, but it is the steepest thing I have ever hiked, far steeper than anything in the grand canyon. Our pictures might give an inkling but not really.

I put up a link to a paper about buy writes, specifically it contained some of risk adjusted numbers that go with buy write.

For some reason the paper focuses on BXD which is the Dow 30 as opposed to BXM which is the S&P 500 but be that as it may; BXD had an average annual return in the roughly ten year period studied of 7.40% versus 7.72% for the Dow and 8.49% for EFA. BXD's standard deviation over that time was 11.44 versus 15.35 for the Dow and 14.95 for EFA.

Anyone who cares about risk adjusted returns will likely be intrigued by those numbers.

I've mentioned this sort of thing quite a few times before and I realized there is on aspect to this concept that I may not have touched on before which is that these sorts of things sometimes do nothing which can create an restlessness which can lead to more trading than is ideal.

We know the market averages 10% or whatever the number is per year. Often most of that positive return comes from one or two big years. I don't have my Trader's Almanac with me but I would venture to say that up a little is probably the most common market condition in a given year. If that is right then a lower octane thing is probably not going to do much. If the market is up 6% one year a low octane device might only be up 4%.

For some stocks 4% isn't even an unusual day. But think about a slow year. A low octane product on its way to a 4% gain probably won't show a lot of movement which is of course exactly what drew you to it in the first place. If something isn't supposed to do much, hopefully you don't get impatient while it, you know, isn't doing much.

I have always been a big fan of low octane but I believe strongly, and have written so, in moderation with these things. I have maintained one call writing CEF across the board for clients and some folks have other, unrelated low octane too but not a lot.

Low octane, like buy write, is great in the context of managing the volatility and other characteristics of the entire portfolio but I have to say that going all low octane or even very heavy is not a compelling proposition for most folks.

A properly diversified portfolio means having exposure to the stock market to capture growth over the long term. This is an important building block before figuring out how much, if any, low octane to own. Just like anything else too much of a good thing is a negative in terms of risk taken, the failed auctions last week as a case in point. Those things were safe and golden and then the concept broke down (I'm sure just temporarily).

It may be tough to believe but too much low risk ends up taking on risk.