Behavioural Investing – How We Make Decisions Impacts Our Future Success
We’re all looking for simple solutions, and for the most part, many of us like to make quick decisions. It is human nature to want to simplify our lives. Over time humans have evolved to the point where we have developed the skills to make quick assessments of our surroundings or current experiences using past experiences as a guide. Unfortunately that can sometimes lead to making quick judgments or assumptions about things where we have some knowledge, but not necessarily the entire picture. Many people fall into that trap when it comes to their investments, making quick decisions based on scant knowledge or outdated ‘rules of thumb’.
I find it fascinating that people will spend more time researching their vacations and flight options online than they dedicate to their investments. They hover over their computers for hours to ultimately save a couple of hundred dollars on a flight or room – an amount that is insignificant in the long-term grand scheme of things.
However, your future lifestyle depends on the decisions you make about your investments today. This is why it is critical to take the time to review and understand the strategies available to you before deciding if something may or may not be the right fit.
In financial matters, a so-called ‘universal’ solution could actually be wrong for you. For instance, a traditional portfolio composed of 60 percent dividend-paying stocks and 40 percent bonds is not as risk-free as many people assume it is. This is why pension funds, endowments and foundations, which are looking for safe and productive investments, have moved away from this classic 60/40 mix. Instead, they have been increasingly using alternative strategies to manage their portfolios.
One of the strategies that merit a second look and careful thought is the use of options in a conservative portfolio. An option is simply the right to buy or sell a security at a given price. At first blush, many people believe that because options are ‘derivatives’ (i.e. their value is derived from the underlying security), then investing in options or using options in a portfolio is always risky. Movies, books and the mainstream media have presented derivatives as bad or dangerous, and as responsible for the downfall of the financial system in 2008 with the attendant financial crisis. (In fact, a more convincing case is that the flooding of the market with poorly understood and incorrectly rated securitized assets, i.e. sophisticated groupings of risky assets [for the most part, subprime mortgages], was the real culprit).
And while some option strategies are indeed quite risky, that is not true of all. In fact, there are two strategies involving options that are considered conservative. These are the same strategies that pension funds have been using for years to help meet their cash flow obligations. Surprised? You may be even more surprised to know that pension funds are the largest traders of options in Canada!
At Exponent Investment Management, we have been using these very strategies in our portfolios for five years to help our clients generate more cash flow to supplement the interest and dividend payments they are currently receiving. Selling options allows investors to harness volatility and convert it into tax-efficient cash. Option premiums, the payment received by the seller (typically called the writer), are taxed as capital gains, not income – which means they are treated in the most favourable way for clients in the highest income tax bracket.
Let me briefly introduce the two conservative option strategies we use at Exponent:
- Covered call writing: This means you are selling an option to someone giving them the right to purchase a stock from you that you already own (hence, the word covered). The price and time period are pre-established. You set a price higher than the current market price, but that you would be comfortable selling the stock for. The person purchasing the option pays you a premium upfront for that right, so you get the cash in hand upfront to sell the call option to someone else. Remember the saying, ‘a bird in the hand is worth two in the bush’? Having cash in hand is the best outcome. Not only that, it is taxed as a capital gain, not as income (i.e. only 50% of capital gains are taxable, while 100% of interest income must be included and taxed at the higher marginal tax rate). In short, why sell an option? To bring additional tax-efficient income into the portfolio, over and above traditional interest and dividend payments, which you continue to receive as well.
- Collateralized Put Sales: These are used in a similar fashion to generate more cash flow in your portfolio. With a put sale, the option buyer has the right to sell you a certain quantity of an underlying security (let’s say shares) at a stipulated price for a certain period of time. If the buyer exercises the option, you must buy those shares from that person at the pre-established price. Why would you sell puts? To establish a price that you would be comfortable paying and that is lower than the current market price of a stock that you want to own. The purchaser of the option must pay you a premium upfront for that right, and once again, that premium is taxed as a capital gain, so you get cash in hand upfront, which is taxed very efficiently as a capital gain. A put sale that is ‘collateralized’ means that you set aside the cash in your portfolio that would be needed to pay for the securities, so you are not caught off guard if the option is exercised.
Using options is an effective way to increase the tax-efficient cash flow in your portfolio while also establishing price boundaries on both the buy and sell sides. You are harnessing volatility and converting it into cash while paying much less tax than if you earned that cash as income. What’s not to like?
So, when it comes to investing and your future, don’t be quick to judge based on cursory knowledge or unexamined assumptions. It is critical to take the time to explore all the various investment strategies available today so you are not missing out on opportunities to enhance your portfolio. If, after doing the research, you determine these strategies are not a good fit for your situation, no harm done. But if you decide they are a good fit, won’t you be glad you took the time to learn more about them and integrate them into your plan going forward?