Tuesday, February 5, 2008

“Worry-Free Investing” Book Review, Part 5

This is the fifth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

In Chapter 7, the authors outline a strategy for investing primarily in inflation-protected bonds (I Bonds) along with a small amount in stock options. Before discussing this strategy any further, let me give a brief primer on stock options.

The simplest kind of stock option is a call option. When you buy a call option, you are buying the right to purchase stock at a particular price. Suppose that Microsoft currently trades at $34 per share, and you decide to buy 1000 call options for $1 each that give you the right to buy Microsoft shares for $40 each sometime in the next 6 months.

If Microsoft stock never gets to $40 per share within 6 months, then you lose the $1000 you spent. If the stock goes to $45 per share, then you can exercise your right to buy 1000 shares for $40 each and then sell them for $45 each. In this case you make a profit of $5 per share minus $1 for the cost of each option. You make a total of $4000.

With options, you can make a lot of money or lose a lot of money fast. All the arguments about stock markets rising and everybody winning don’t apply to options. Call options are essentially a bet where the option buyer gambles that stocks will go up, and the option seller gambles that stocks won’t go up. It is a zero-sum game except for the costs of commissions and spreads. The average participant in stock options loses money.

Given $100,000 to invest, the authors’ suggest buying enough (I Bonds) to get back the $100,000 plus inflation after 3 years, and put the small amount that is left over into call options on the whole stock market. With this strategy, you won’t lose money, but you are combining a low-return investment (I Bonds) with an investment whose expected return is negative. If this sounds bad, it’s because it is bad.

In rolling 3-year periods between 1926 and 2000, buying stocks was better than this strategy 79% of the time. On average, stocks were better by $12,800. Now let’s consider repeating this strategy 10 times over a 30-year period. In rolling 30-year periods from 1926 to 2000, stocks were better than this strategy 100% of the time by an average margin of $409,000!

It turns out that safety can have a very high cost.

We continue with part 6 of this book review next.

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