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Two investment suggestions from GMO [ClearOnMoney]
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Two investment suggestions from GMO

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Commentary

Two investment suggestions from GMO

7 Feb 2013 by Jim Fickett.

The latest quarterly letter from GMO was out on Wednesday, with an article on diversification by Ben Inker entitled, “We have met the enemy, and he is us”. Most of this article discusses the idea that when diversifying investments become too popular, they lose their value for diversification.

Towards the end of the article there are two interesting suggests for particular investments.

One is selling put options in the current, somewhat overvalued stock market. The idea is that (1) the risk side of the equation is the same as owning stock directly – if the stock on which you sold a put option (at the current price) goes down 10%, you lose the same 10% you would lose owning the stock directly, but (2) the reward side of the equation is quite different – if the market languishes, you get nothing owning the stock directly, but you get the premium for selling the option.

If you sell an at-the-money put on the S&P 500 and the S&P 500 falls by 10%, you lose the same 10% that you would have if you owned the S&P 500 directly. The difference is in the way you get paid. If you own the S&P 500, your payment for bearing the risk of the S&P 500 going down is the right to participate in the S&P 500 going up. If you sell a put, you get paid an option premium but do not participate in the market’s upside. In the period that listed options on the S&P 500 have been around, selling put options on the market has given you more or less the same return as owning the market. While puts have had a “lower volatility” than stocks over this period, we don’t think of this fact as evidence of a market inefficiency. The reason you get paid a risk premium on stocks is because of the size and timing of the losses stocks give investors, and put selling exposes you to that same exact risk, and consequently should give the same return. But we still think of put selling as interesting diversification within an equity allocation because of the difference in the way you are getting paid. When equities are overvalued, there has historically not been that much upside to the market, but the return to selling a put option has been largely unaffected, since the option premium has remained fairly stable. At a time like today, where many equities look to be significantly overvalued, the prospect of getting paid a “normal” equity risk premium for selling puts looks pretty attractive, and we have therefore added put selling as part of the equity portion of a number of our multi-asset portfolios.

The second suggestion is owning quality stocks rather than, or in addition to, somewhat cheaper stocks, such as the depressed equities of Europe. The idea here is that quality stocks, defined as those having predictable earnings, are likely to hold up better in the next crisis.

Another example of a diversifying asset is quality stocks. The primary reason that we own quality stocks today is that they look much cheaper than the overall U.S. stock market, but another consideration in their favor is the fact that they are very likely to have more stable cash flows than other companies during a depression or financial crisis. Given that most of the other equities we find attractive today, such as continental European value stocks, would be particularly vulnerable to either depression or crisis, we feel quality is a particularly valuable version of equities to own, and quality makes up a larger percentage of our equity portfolios than its pure forecast would suggest.