If academics where financial geniuses, they wouldn’t be academics.

From 1871 to 2008, the average rate of return for the stock market has been 8.76%.

That number and similar long term numbers are thrown around regularly as to why the stock market is still the best place to invest long term. This is absolutely true if you are Yale or Harvard, and your trust fund really will survive for hundreds of years, but for mere mortals, we need to take a few other things into consideration.

First, most people don’t start saving seriously when they first start working. Second, even those serious savers aren’t saving number initially, because their income increases so much the first 5 to 10 years of their careers. So instead of looking at a 137 year window of investing, the window should be much smaller.

Most people who do a good job saving will be looking at a 30 year window before they have need to start making draws against their retirement funds. So instead of looking at the average rate of return over 137 years, people should plan for the worst 30 year period that we have experienced, and know that it could be worse than that.

Doom and gloom I say? It could be worse than that? The average rate of return ending Feb 28, 2009 was -5.8% for the last 10 year period (45% loss overall). There are two strong bull markets and two strong bear markets in that time period, and the bears won.

I am not even considering inflation. If you retirement started at the end of Feb, you were probably worth about half what you were a year earlier. You could have stuck everything in a savings account in the beginning of 1998, missing out on another 56% gain from the internet boom, and still been much better off than if you had left everything in the market from 1998 to 2008.

Instead of using 8.76% in your calculations, use 5%. 5.09% was the lowest compounded rate of return I found for a 30 year period. If you plan for 5% growth, and get lucky enough to average 10% growth, it is much easier to live on extra money then not enough.

My conclusions, pension funds managers are idiots.

First, lets say you are a company that has been around forever, has grown considerably over that time, employees pay into the pension 20-40 years and the payouts lasting 20 years. The company has grown and so has the number of employees funding the pension. In good times like these, the pension should be net positive cash flow. By this I mean the outgoing retirement benefits being paid are less than the incoming funds from existing employees, thus the pension fund has a growing net asset base and the existing base is never touched.

Now, in this ideal situation, I believe that this is true.

Next, take a company (or government) that provides a pension and has grown linearly with time, or just at a much low exponential rate than a highly successful company. The cash flow should still be net positive, because you have more people paying in then are taking a draw.

In this situation, I do not believe this is true, because pension fund managers allow companies (and governments) to underfund the pension, creating a cash flow problem, and thus to meet current obligations, assets have to be sold, thus decreasing the size of the pension. Thus, pension fund managers are idiots.

Finally, take a company that offered a pension, but is now bankrupt. If this company has met all obligations to date, the remaining balance in the pension should allow the pension to make payments for 20 years.

In this situation, the funds start out underfunded and the asset base, the portfolio of the pension, contains too much risk. Not only could the pension not meet obligations because it started out underfunded, but being invested in risky assets means that there is variable chance that the pension will even last as long as its current value would indicate. Thus, pension fund managers are idiots.

My thought process was that I wanted to risk no more than 10% loss from the price in January, and in January I would buy PUT options with a strike price 10% the current price, with an expiration one year away. This would insure that my portfolio would be worth no less than 90% what it was worth in January.

Good idea, and I am sure we all would have liked to do that last January.

The problem is that the cost to do this would be about 10%/year. No one can afford to give up 10% a year and still come out ahead over time. Even selling covered calls to offset the cost of the insurance, it seems like a lot of risk.

What I noticed, but have not fully researched, is that in the money calls might be cheaper long term, but more expensive short term. In the money options always cost more than out of money options, because they have intrinsic value. If they were executed immediately, the executor would be on the favorable side of the transaction. An in the money call option has a underlying stock price worth more than the strike price, so executing immediately would allow you to follow up with a sale for a positive return. It makes sense that an in the money option costs more than an out of money option.

So how does in the money options work for insurance? You would buy a PUT option with a strike price higher than the current trading price of a stock. For example, SPY is about $83 right now, and a PUT with a strike price of 100 is $17 in the money. If I bought a PUT with a strike price of $100, I could execute it immediately, and someone would pay me $100 for my $83 SPY. Now the PUT will cost more than $17, and the difference between the $17 and the real price of the option is the time value of the option. For a option that expires in a year, that time value should be quite a bit.

The question is, if I buy in the money PUTs, will the time value be cheap enough that I can afford to insure my portfolio?

I started out wanting to do naked puts, where you get paid to buy a stock if the stock price drops below a certain point. Originally, I wanted to sell Google puts at $250, which would make about $5/month, and if it gets executed, you would end up with Google at $250. Google at $250 is a P/E of about 15, which I would be happy with, no matter what crazy nose dive the market took for Google to hit that price, since I wouldn’t be selling Google any time soon, and I would be paid to wait for it to hit my target price. The problem is, I need $25k sitting around so that I can buy the stock when the target gets hit.

So then I started thinking about put spreads. You sell one put, saying you will buy a stock if it drops too much and collect a fee, and buy one put, saying someone will buy your stock if it drops even more. The first put is more expensive then the second put, thus you are credited the difference between the two put prices. The second put provides you with insurance, so the most you are at risk is the difference between the two put strike prices. This is called a bull put spread, and it is a strategy you use when you think the market is going to be flat or go up in the next 30 days.

But I don’t really know what the market is going to do.

If you don’t have an opinion on the market, maybe a market neutral strategy is a good idea. I am reasonably confident that the S&P 500 will stay below 950 for the next month, and above 800.

Since I hold that believe, then an iron condor makes sense, which is a highly profitable strategy when the market is flat. The market isn’t currently flat, and that is why my high guess and low guess are so far apart.

So what is an iron condor. An iron condor is a call spread for a credit paired with a put spread for a credit, both side providing a credit. The benefit of the pairing is that only one side can be a loss. The downside is, the loss on that one side is usually enough to make the entire iron condor a loser for the month. The goal is to pick high and a low that the market will not reach, but still generate enough credit so the trade is worth doing.

This is where risk management comes into play. Iron condors lower your financial exposure, but if the market rockets in either direction, iron condors are losers.

Lets say I thought of this last January, and I bought an equal dollar value of long Toyota and short Ford.

• January 2, 2008, sell 1,515 shares of F (Ford) at $6.60/share and buy 93 shares of TM (Toyota) at $106.46/share.
• December 30, 2008, sell 93 shares of TM at $65.44/share and buy 1515 shares of F at $2.29/share.

Uh oh, those numbers don’t look good. Both Toyota and Ford devalued.

I bought about $10,000 of Toyota stock and sold $10,000 worth of Ford stock, which I borrowed from my broker and have to return at some point. When I sold my Toyota, I made $6,085.92 (Ouch!). I bought 1515 shares of Ford for $3469.35.

So how much money did I lose on my virtual trade?

I made $2,714.79, or 27% return on the $10,000. The return on investment is not really correct, because this strategy actually carries unlimited risk since Ford could have gone up infinitely, while Toyota stayed the same or went down. The odds of that happening seem acceptable to me.

Now, after I thought of these little scenario, I also realized that I picked Ford, which is the healthiest of all the American car companies. I should I picked GM, since it is on the verge of bankruptcy and Chrysler is privately held.

If I would have picked a worse American car company, how would I have faired?

If I would have picked the GM over Ford, I would have made 48.6% return on my $10k.

This makes a lot of assumptions. One, that there are no costs associated with a short sale (there are and they are about 10% APR for me). Two, that I could have picked this scenario last year, but all i picked was that Toyota would out perform Ford, not exactly genius.

What wasn’t an assumption but is necessary for these kind of returns is a catastrophic event for the short company in a bear market or a outstanding return for the long company in a bull market. Without the best company significantly out performing the worst company, the cost of the short sale will likely create a losing trade in real life.

What I don’t know is if I could structure the same approach with options, providing a fixed risk and eliminate the costs associated with the short sale. I am pretty sure I can, and I imagine that the sector spread is not uncommon or original.

After looking at my gross pay for the year, and my net pay, I have come to the conclusion that I need to start a government. For every two subjects of government QBrain, I will make the same income I do now, assuming my loyal subjects make the same salary I do. If they don’t make the same income I do now, I will just get a LOT of subjects to pay me, and then not really worry about how I spend. I can always deficit spend if my subjects are not generating enough revenue to meet my needs. Does my plan seem a little willy nilly compared to my typically detailed grand schemes? Well, it is a government, and you never know what need might arise over the horizon, so I just plan to what I need when and need and let the details work themselves out this time around.

So, come and join government QBrain. Just send me a third of your income, and I promise to make grand promises, and show you very little direct benefit to how I spend that money.

You know who buys the majority of Luxury goods? Is it the ultra rich? No, it is the normal Joes who are splurging on an up market product. Look around and you will see a fair share of 20 somethings driving around in Lexus and BMW. Good financial decision? No, but credit was easily available, and it was a status symbol so it was purchased, or leased.

This isn’t something that is limited to status focused 20 somethings, everyone does it. It might be a purse, or a car or a pair of shoes, and when there is extra disposable income, everyone has an upgrade they would like to partake in. If luxury brands truly only catered to the super wealthy, they wouldn’t have stores in malls.

I believe this happens at all levels, and during an economic downturn, people return to the level the are most comfortable at. If this is true, and Wal-Mart is the bottom rung retailer in the US, then Wal-Mart isn’t actually going to experience some growth. This is also a financial theory I have seen in the news a lot, but if everyone is stepping down their spending, how can luxury goods be immune to economic downturns.

Two economists, two theories that cannot both simultaneously exist. Good job guys! And thanks Big News for repeating their rubbish.

Now, don’t get me wrong. I think most financial advisers are worthless at best. But if you have an adviser that is leading you down a path that is better than the path you would have chosen on your own, then they are providing a valuable service.

If your plan, that you developed with strong input from your adviser, that you followed, was to mitigate market risk, by taking lower return for more security and your portfolio dropped faster than the market in general, you should fire your adviser.

But, if your adviser and you decided that you were young, and you had many years of growth ahead of you and you were ready and willing to suffer increased risk for higher return? Your portfolio should, quite acceptably, have dropped faster than the market.

There are three types of long term individual investors in my eyes (highly generalized). There are the people under 40, who are looking from strong returns and have the years to deal with increase market risk that goes along with them. There is the 40 to 60 crowd, who is starting to shy away from market risk, and are selling off their more risky investments and reinvesting the money in less risky assets. Finally there are the 60 and up crowd, who really can’t tolerate risk and bang their head against the wall trying to figure out how to invest their large portfolio, risk free, and still keep up with inflation.

All three of these groups, sadly, are still exposed to under performing the markets. They all still have needs of growth, and even the groups who want to move to riskless investments still have to deal with tax consequences finding those “riskless” investments.

Advisers should be fired because they typically impede financial growth, not because they underperformed the shittiest market since the Great Depression. If you are saving because you meet with someone twice a year, but otherwise would spend that money, than that adviser is worth the 1% fee he charges. He is the difference between having savings and not having savings. Preparing for retirement or living off of social security checks when you can no longer work. He has value, even if his plan underperformed the market in 2008.

In general, covered calls are a conservative strategy, where you sell an option for someone else to buy a stock you already own. Your goal is for the stock to slowly go up, thus, it is never profitable to execute the stock, you keep the option premium and you keep the appreciating stock.

In the recent market, you have no idea what the market will do 30 days from now, or even tomorrow. Volatility is at an all time high, and I want to take advantage of it.

My idea is to buy QQQQ, which is the nasdaq index etf trading around $30. Then sell a covered call at around $2 at the money. The goal would be to sell the option at a price that would get exercised, ending the month completely in cash again. If strategy outlined above worked out exactly as described, it would generate 6.7%/month. After accounting reality and trading costs, this strategy still looks like it could generate 5%/month. And what is 5%/month compounded? Close to 80%/year.

The first thing my wife will ask is, if you can make 80%/year, why isn’t everyone doing it. First, high volatility means high risk. I am interested in QQQQ because it is an index ETF I would not mind holding in my portfolio for its current value. QQQQ could drop 20% over the next month, and then that 5% return on the option doesn’t look so hot next to the 20% loss on the underlying stock. Second, volatility is at an all time high. People are making money of this oddity, but covered calls are typically used for low volatility stocks, so the people who typically use a covered call strategy to eek out small gains, have stepped aside since market conditions now make it risky to continue to sell calls. Third, this volatility level will not continue forever. Once the markets calm back down, the option premiums will drop, and the strategy will be less profitable.

As an example of how much the volatility changes things, let me outline roughly what I was doing with covered calls a few years ago and what the market looks like now. A few years ago, I had an index backed etf that was trading about $70/share. An option one month out was trading at less then $0.90 consistently, and to make over a dollar, an option had to be sold in the money or more then a month out. Now there is an index backed etf trading about $30/share, and an at the money option one month out is trading for about $2. To simplify, lets say the first period had options trading at $1 at the money, one month out. That works out to be $1/$70=1.4% return versus $2/$30=6.7% return. So you need less then half the investment to make twice the return. With a goal of income, this is the market to sell covered calls.

Obviously the premiums have increased in cost because of the increased risk associated with holding the underlying stocks. Does the reward justify the risk? That is the research I didn’t get to in my short weekend.