3 Ways to Create a Diversified Portfolio

When it comes to investing our money, we always hear that a diversified portfolio is the best way to go. According to the wisdom of the day, the most common diversification is provided by a portfolio of stocks and bonds. But, is that really the case? Recently, my favorite research team of traders at tastytrade.com provided some insight into whether, or not a portfolio divided equally between bonds and stocks outperformed a portfolio of options. 100% of the available capital was allocated to the stock/bond portfolio, but only 25% was allocated to the options portfolio.

Diversification with Stocks and Bonds

It is generally stated that diversification is critical for risk control over the long term. We have heard this from every adviser we have ever known. So, let’s’ take a look at the historical performance of these different approaches.

For the past decade the SPY(stock ETF) and TLT (bond ETF) have shown a strong negative correlation, which is ideal for portfolio diversification. When Stocks move up, Bonds moves down. For comparison’s sake, we’ll call the stock/bond portfolio our ‘Buy and Hold component.  This portfolio will have 100% allocation of our capital 50/50 between SPY and TLT.

Diversification with Options Portfolio versus stocks/bonds

Instead of using stocks and bonds, if we use 50 delta Puts in both the SPY and TLT and allocate 25% of our capital (12.5% in SPY and 12.5% in TLT) and manage our winners at 50% of max profit, the options portfolio yielded almost the same profit and loss as the Buy and Hold portfolio.  We are using only 25% of our available capital in the options portfolio compared to 100% in the Buy and Hold portfolio. That’s a significant outperformance.

That sounds great, you are saying, but, aren’t options much riskier that stocks and bonds.

Comparable Performance with Lower Volatility

Well, the research went on to show that not only was the monthly P&L greater, but the options portfolio gave this return with lower volatility.

So, the next time someone tells you that a Buy and Hold portfolio of stocks and bonds is the better way to garner diversification, tell them that Options Portfolio could do just as well in the long term.
If you’d like to know more about this kind of research, check out tastytrade by going here www.tastytrade.com.

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