Asset allocation is extremely important

yager

Sat, Jan 19, 2008

Options Education, Strategy

Asset allocation is extremely important.

Maybe it’s tempting to think that just because you’re using a risk-defined strategy (whether iron condors or butterflies or vertical spreads or whatever else), diversification and smart portfolio management don’t matter any more.

But that’s pure madness. We’ve actually heard horrifying tales of people allocating huge chunks of their total capital to just one or two trades. But just as you wouldn’t put 30% of your total account into AAPL or GE or IBM stock, or put 30% of your account into front-month OTM QQQQ calls (one hopes), so you shouldn’t plunk a lion’s share of your total account into any one position. The fact is that no matter what strategy you’re using, and no matter how well it performs (all strategies have losing trades and drawdowns), if you don’t diversify your portfolio, you’re going to get burned. Asset allocation is extremely important.

Here are some general guidelines:

1. Start small. You can always increase an allocation later on. Sometimes a given product or strategy won’t react to different circumstances in the way that you expect it to, so if you begin with conservative allocations, any downside surprise won’t have an undue impact. Once you’re comfortable with the way that a given equity or position trades, you can dial up your allocation as desired.
2. Use many, many baskets. Ideally, no one position should ever occupy more than 1-5% of a total portfolio. And if you can allocate even lower than that, even better. Ok, this is Investing 101, but that doesn’t make it any less true: if for some reason you’re in the habit of carrying eggs around with you, if you put all those eggs in just one basket, then if you drop the basket, all of your eggs will break. Now, maybe eggs don’t belong in baskets in the first place - after all, those styrofoam cartons we all use seem to work pretty well. But in any case, if you’ve got lots of baskets in which to divide up your eggs, you dramatically decrease the odds of losing lots of eggs to breakage. The non-metaphorical point, again, is to divide your trading capital up amongst many, many positions.
3. Trading vs. Investing. The old distinction between trading and investing has never been more blurry. If you buy some AMZN stock and it tanks on you, and you get out, is that still an investment? If you buy some 2009 DIA LEAPs, is that still a trade (presumably because you’re using options)? But however you define trading and investing, it’s important to keep a balance of conservative and aggressive positions in your portfolio, based in part on your timeframe, intentions for the portfolio, etc. In other words, if you’re hoping to retire in a few years, don’t go trying to double your portfolio - no matter what the instrument is - because that entails a lot of risk and is likely to blow up in your face. There’s a good reason financial planners increase your bond and fixed income exposure as you get older.
4. Size matters. Portfolio size is an important factor, and portfolios of different sizes have to be allocated differently. For example, very small portfolios sometimes require more work, not less: because in many cases transaction costs have a bigger impact on small portfolios, it sometimes makes sense to allocate on the higher end of the spectrum (i.e. closer to the 4-5% mark than to the 1% mark) in order to reduce the impact of transaction costs.
5. The Gut Test. If all of the above is too vague or abstract, here’s something thoroughly visceral. Punch yourself in the stomach. Now take a moment to savor that pain. And ask yourself if you’ve felt any similar sensations during any recent market selloffs. If the answer is yes, odds are that you’re not properly allocated, and/or are taking on more risk than you can handle. Trading shouldn’t involve upset stomachs, shortness of breath, or intense mental anguish (leave that to our pharmaceutical industry). If you find yourself developing a strong emotional relationship with any single position, you should a) get out more, and b) dial down those allocations.

It should go without saying, really, but diversification doesn’t go out the window just because you switch strategies or decide to start trading options, futures, forex, or whatever else. Maybe it’s a feature of human psychology that we don’t want to hear about the risks and dangers of something. Maybe “options involve substantial risk and are not suitable for all investors…” is just more difficult for the reptile part of our brains to process and “X% returns every month” is too overwhelmingly attractive.

But that’s no excuse, really, because ultimately, asset allocation is even more important than what trades you place or what strategies you use. Every strategy is going to have winning and losing trades, and every trader will have good days and bad ones. And over the long run, the only way to survive the bad trades and live on to have better days is to practice smart asset allocation.

Asset allocation is extremely important.

[NOTE: This post is for general information purposes only, and is obviously not provided as individualized advice. We don't know your investing goals or timeframe, your financial situation, your risk profile, or any of a host of other relevant factors, so by no means should our specific opinions about allocation - including the 1-5% rule - be taken as fact and acted upon by you, just because we said so. Ideally, you should educate yourself so that you can plan your own financial future; failing that, at least consult a registered financial adviser.]

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