Become a Stock Market Landlord January 29, 2017
Stocks are for buying, not renting.
Or are they?
The fact is that stocks can be used for consistent income while reducing the volatility (or risk) of holding stocks.
This is done by selling the rights to a stock for a pre-determined period of time to someone else, sort of like you sell the rights to a rental house to your tenant for a month in return for the rent.
In stock terms, rent is called premium. You collect premium when you sell someone else the right to buy your stock from you at a specific price at some future date. Sort of like a rent to own arrangement.
How does it actually work?
In stock investor parlance, it’s known as “writing options” or more accurately “writing covered calls.”
It’s simpler than it sounds. “Writing” is Wall Street jargon for selling. “Covered” just means that you actually own the stock you are selling the purchase rights to. In the stock market, unlike the real estate market, you can sell someone the rights to a stock you don’t own (by the way, don’t do that- very bad idea).
“Call” just means that the buyer of the right to purchase can take your stock under certain conditions, or “call” it away from you.
So, you are selling someone the right to take possession of a stock you own, at some future date, at an agreed upon price, in return for a payment to you.
Well, wait a minute, some of you may be saying. If I do that, I lose the appreciation the stock is going to have when the market rallies. And you would be partially right – when you sell someone the right to purchase your stock at a certain price, you lose any gains above that price.
But this is overrated. The fact of the matter is that about 70% of the time the stock market doesn’t do much. It sort of trucks along while it moves a bit up and a bit down. During bear markets it moves down more, during bull markets up more.
But here’s the rub – if you collect premium on your stocks during the 70% of the time the market isn’t doing much, those rents (and dividends) pile up so much that missing the rallies doesn’t matter because you are also missing much of the valleys.
As you can see from the below, missing the rallies hurts, but missing the rallies and valleys is how the most successful investors do it – they aren’t worried about catching the next rally, instead they are looking to make their returns as consistent as possible while managing their risk of loss. They look for singles and doubles rather than home runs, while keeping an eye on the sky and trying to avoid any storms that roll in.
It turns out there is actually an index that tracks this call writing strategy. It’s called the CBOE Buy/Write Index or BXM (as an aside, it’s important to note you can’t actually buy shares of BXM. One more example of life’s sometimes perplexing realities).
Here’s a graph of what $1,000,000 invested in the S&P 500 and $1,000,000 invested using the Buy/Write index (after adding hypothetical dividends which you would get if you bought an S&P index fund and then wrote covered calls on it monthly) looks like over the last 15 years. Just for fun, let’s pretend you have to take out $50,000 a year for college expenses, or to pay for vacations, or even just to cover living expenses ($4,166 per month).
It’s pretty clear that being a stock landlord is a way to both get greater consistency of returns while reducing risk.
It’s also pretty clear that using the BXM index as an investment model makes a heck of a lot of sense, especially for older folks or investors that want to keep a lid on investment risk.
In fact, this strategy makes so much sense, it’s one of ACI’s core portfolio strategies – we call it Market Income.
If you cut investment by 50% when the US moves into recession, things get even better.
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To Smarter Investing,
ACI Wealth Advisors, LLC.
Process Portfolios, LLC.
Additional Disclosures regarding hypothetical illustrations:
It is not possible to invest directly in an index. The above hypothetical chart makes the assumption that an investor can mimic the strategy of the BXM index using a dividend yielding S&P 500 index tracking fund. This discounts the emotional impact events might have on an investor and makes assumptions with the benefit of hindsight. The illustration does not take into consideration the impact of management fees on the S&P 500, the 60/40 Stock/Bond portfolio, or the hypothetical Buy/Write with dividends portfolio prior to 2014. From 2014 on ACI’s Market Income Portfolio’s live results including fees has been substituted for the BXM index, which is when ACI begin tracking the Market Income strategy as a distinct portfolio. ACI’s Market Income has significantly outperformed both the BXM index and the S&P 500 with less risk since inception to date. Past performance is no guarantee of future results.
There are inherent limitations in hypothetical or model results as the securities are not actually purchased or sold. They may not reflect the impact, if any, of material market conditions which could have has an impact on the manager’s decision making if the hypothetical portfolios were real. Hypothetical performance is shown for illustrative purposes only and should not be interpreted as an indication of performance of any ACI portfolio.
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