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As Sam Sees It: How Investors Can Get Something for Nothing

By  +Follow July 3, 2014 7:09AM
Tickers Mentioned:

passive investing, best investment strategies, low risk investment strategies, safe investment strategies

Each week, we tap the insight of Sam Stovall, Managing Director of US Equity Strategy for S&P Capital IQ, for his perspective on the current market.

For more from S&P Capital IQ, be sure to visit www.getmarketscope.com.

EQ: They say there’s no such thing as a free lunch, but diversification is as close as investors can get. What does that actually mean when they say that?

Stovall: In most cases, “no free lunch” means investors don’t get a higher return without paying for it in the form of higher risk. You don’t get something for nothing. If Sir Isaac Newton had a fourth law, it would be that for every level of return there would be an equal level of risk.

So actually, a diversified portfolio is the closest thing to providing you with a free lunch because if you put together asset classes that have low-to-negative correlation, then they might both take the stairs, but at different paces.

For instance, when you think of modern portfolio theory, it says that you want to maximize returns while minimizing risks. You can’t necessarily eliminate risks, but you can certainly minimize them. That’s why investors typically match up stocks with bonds because bonds usually have low correlation and even a negative correlation at times to stocks.

Sometimes, however, people don’t go far enough and they confuse quantity with correlation, thinking that having exposure to large-, mid-, and small-U.S. stocks, while also having developed international and emerging markets, as well as commodities and real estate, makes them well diversified. But, in fact, they are not because all of these asset classes are economically sensitive. They’re markets that are triggered by global economic declines, which tend to bring all of these asset classes lower.

In a nutshell, a free lunch comes from properly diversifying a portfolio where one asset class zigs when the other one zags.

EQ: In this week’s Sector Watch report, you discussed the “Free Lunch Portfolio,” which focuses on three sectors of the S&P 500: Technology, Energy and Consumer Staples. Why focus on these three?

Stovall: It was sort of a building process. I first was a little bit surprised to see that even when you include the dot-com bubble bursting in the early 2000s, Technology was still the best-performing sector within the S&P 500 since the sector indices were first introduced in 1990, producing a 9.6% compound rate of growth. However, investors paid for that return in the form of very high risk and volatility as defined by a standard deviation of annual returns.

So if Technology is the poster child of cyclicality, I wanted to identify the section that is regarded as the most defensive. That’s when Consumer Staples came up. For Energy, it tends to behave like a stray cat marching to its own beat, but at the same time, is also a late-cycle performer and an inflation edge.

So those were the three sectors that caught my attention. Then, when developing a strategy of one-third Energy, one-third Staples, and one-third Tech, and seeing the returns on an absolute basis as well as a risk-adjusted basis, I got my confirmation that these three were very good holdings within an overall sector portfolio.

EQ: What kind of performance did this strategy produce as compared to just investing in the S&P 500?

Stovall: My assumption was that by offsetting the volatility of Technology with the defensiveness of Consumer Staples, I would not get an absolute return that exceeded that of Technology, but I would’ve received a risk-adjusted return that was better in comparison, and hopefully better than that of the market as well.

As I mentioned, since 1990, the Technology sector has posted a compound annual growth rate of 9.6%, but its volatility was almost twice that of the S&P 500. The return of the S&P 500 was 7.1%, but surprisingly, the “Free Lunch Portfolio” posted a compound rate of growth of 9.8%—better than Tech—and its volatility was even less than that of the overall market.

So indeed we did get something for nothing. We got a substantially higher return with remarkably lower volatility by holding an early cycle in the form of Tech, a late cycle and inflation hedge in Energy, and a sector that holds up best in a declining market with Consumer Staples. We also ended up with a strategy that beat the best-performing sector of all.

EQ: As you stated, this is a good strategy for those that want a simple set-and-forget portfolio. Considering that investors are faced with so much more technology, information, opinions, and just all-around options now, do you see an increase in the tendency to overthink how they approach the market?

Stovall: Yes, I think investors do, mainly because I know I do. We have so much information available to us, so much historical data and so much academic research that we can apply to our portfolios that you end up being your portfolio’s worst enemy, and probably because you’re frozen by indecision.

There is so much data that could end up talking you out of making wise investment decisions. The reason why I say this is a set-it-and-forget-it type of portfolio is because you don’t need to know where we are in the economic cycle. If we’re in the early phase, then Tech will do well. If we’re in a late phase, then Energy will do well. If we’re in a contractionary phase, then Consumer Staples will do well. Over the long haul, stocks in general will do better than cash or bonds.

So my feeling is you just put it together and not worry about where we are in the cycle since most people don’t know anyways, and just let it ride. If you wanted to engage in rebalancing, which is recommended in order to get similar kinds of returns—but there’s no guarantee you will—you don’t have to sell anything. Just simply purchase more of those sectors that did not do as well, and that will allow you to rebalance without having to take any taxable consequences.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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Results for SPY
Gary Tan
18 Dec 14 18:12:59
RT @nanexllc: 4 seconds before close a massive $200M worth of $SPY trades in a second (2000+ trades) - sending prices from 206.76 to 212.97…
Gary Tan
18 Dec 14 18:12:25
RT @nanexllc: Classic. The high in $SPY (for the year?) was set by a fat finger + broken markets. You can't make this up
18 Dec 14 18:12:20
RT @StockTwits: There was a giant "FLASH SPIKE" right before the market closed. Just look at this chart -> http://t.co/xG0os88zk5 $SPY
R Fraser
18 Dec 14 18:10:11
RT @nanexllc: $SPY spike wasn't 1 trade. Or 10, or 100. It was 1,147 trades (610K shares): http://t.co/WpNQsnVJyh
TV_Trading Ideas
18 Dec 14 18:10:08
SPY $SPY http://t.co/xbnTUfkSvq
18 Dec 14 18:10:08
$SPY chart: SPY. http://t.co/kwq3aCP04J
Lake Ave Financial
18 Dec 14 18:08:05
The #Dow jumps over 400 points today as #tech #stocks lead the way on #WallStreet. #DJIA $DIA #SP500 $SPY #NASDAQ $QQQ
Don Garabedian
18 Dec 14 18:07:18
RT @YahooFinance: 5th longest period is 50 years without a 10% correction http://t.co/YVR8LTvbDm via @KimbleCharting $SPY http://t.co/Yy5i8…
Justin Pulitzer
18 Dec 14 18:05:13
RT @nanexllc: $SPY spike wasn't 1 trade. Or 10, or 100. It was 1,147 trades (610K shares): http://t.co/WpNQsnVJyh
18 Dec 14 18:04:52
Vish: $SPY - got over 207 .. jesus christmas - Vish http://t.co/G3ThvMLI7C
18 Dec 14 18:00:52
$SPY Max Pain = 201.00. Maturity = 12/20/2014. Previous close = 206.78. http://t.co/fuRTmPHDWo
18 Dec 14 18:00:06
#ThrowbackPost $spy Things To Look For When Buying A House http://t.co/Z1EziUfbKH
18 Dec 14 17:59:44
#TOPTICKERTWEETS $SPY $AAPL $IWM $SPX $QQQ $HERO $DIA $BBRY $AMZN $UPIP #quantheta #sentiquant 20141218 21:00:16:953
18 Dec 14 17:57:16
RT @sentrade: Wow...today's move in $ES_F certainly caught me by surprise. $SPY
18 Dec 14 17:56:52
RT @sentrade: S&P increased +29% Bulls over the past two days. $ES_F $SPY
18 Dec 14 17:56:37
RT @sentrade: That's the largest two-day gain since the 2009 bottom. $ES_F $SPY
18 Dec 14 17:56:26
RT @HedgeBound: Let's do some Math. Hedge Likes Math. If I BUY 1,000 $SPY Calls and I tend to buy .70 Delta Calls & $SPY Rips +$4 that's $2…
18 Dec 14 17:56:26
$SPY - "The List" Courtesy of #IBD50 looks completely different than 9:29AM Wednesday http://t.co/7Ko5QZI5cx opposite http://t.co/EHLbattfRt
18 Dec 14 17:56:23
RT @sentrade: Previous record was +24% Bulls between 07/21/10 and 07/23/10. $ES_F $SPY
18 Dec 14 17:56:06
RT @JLyonsFundMgmt: (Post) An Unprecedented Rally Part 1 - via @YahooFinance $SPY http://t.co/nTI2EogKcB
18 Dec 14 17:53:48
@WallStreeTopGun are your $spy puts pure lotto..
Alpha Maven
18 Dec 14 17:52:28
RT @chessNwine: NEW POST: Stock Market Recap 12/18/14 {Video} http://t.co/KHIU6pFNHF $AAPL $JNUG $RUSL $SPY $TSLA
18 Dec 14 17:51:45
Jury Rules Apple Did Not Break Antitrust Laws With iTunes http://t.co/d0MkEHLp7Q $AAPL #Stocks #Investing #NYSE #NASDAQ $SPY $IWM $QQQ
Ben Williams
18 Dec 14 17:49:39
RT @candidbanter: 421 point up day in dow and no one investigates....yet one dow day of 421 will bring in the government.. #stocks #tradin…
18 Dec 14 17:49:15
@optstrategist $VIX buy system works like a charm. Made some $ in one day on a sale of $SPY puts. Thanks!
Lonny Jones
18 Dec 14 17:48:10
RT @lancejepsen: Running with the Bears in the Financial Sector ETF $XLF $FAZ $SPY http://t.co/QuqcNcuRcX http://t.co/MAcL5YvLfO
Options Trader
18 Dec 14 17:47:33
Brazil's Rousseff vows clean-up of scandal-tainted Petrobras: SAO PAULO (Reuters) - Brazilian P... http://t.co/E7IesCsRxn $SPY $QQQ $IWM
Inside Stock Alerts
18 Dec 14 17:47:33
Brazil's Rousseff vows clean-up of scandal-tainted Petrobras: SAO PAULO (Reuters) - Brazilian P... http://t.co/vFGbPctFTr $SPY $QQQ $IWM
levi frazier
18 Dec 14 17:47:31
The reason for the spike in the $spy today. TED Talks, Kevin Slavin http://t.co/DjjoROgZZH
Edward Gofsky
18 Dec 14 17:47:28
RT @chessNwine: NEW POST: Stock Market Recap 12/18/14 {Video} http://t.co/KHIU6pFNHF $AAPL $JNUG $RUSL $SPY $TSLA
18 Dec 14 17:43:58
$SPY $DIA $QQQ $NDAQ theeze r massive movez in 2 dayz 4 "newz" we already knew.if they cured cancer or world hunger or war maybeey warranted
US Consumer News
18 Dec 14 17:43:17
SPDR S &P 500 ETF Trust Director Kevin Robert Taylor Buys $2,695 in $SPY http://t.co/zXYwhH2u2d
US Banking News
18 Dec 14 17:42:38
SPDR S &P 500 ETF Trust Director Kevin Robert Taylor Buys $2,695 in $SPY http://t.co/NbdMk4EDuU
USO Fractalerts
18 Dec 14 17:42:33
Tell us what you think about this weeks $SPY alert. How are you trading it? http://t.co/kRspp8NHje
18 Dec 14 17:42:23
Every time I see the word 'cheer' in financial headlines I vomit a little in my mouth $DIA $DJIA $SPY $SPX
18 Dec 14 17:41:48
RT @DarvasTrader: Though we added another Distribution Day today, I'd avoid making any major moves right before a Fed statement. $QQQ $SPY
Stock Market Picks
18 Dec 14 17:41:44
Earnings Releases for December 19th (before the open): $BBRY $CCL $FINL $KMX $PAYX http://t.co/cyxQj8igqB $DIA $QQQ $SPY #stocks #trading
Option Millionaires
18 Dec 14 17:37:47
RT @UPBOptionMil: $SPY Option Feeding Frenzy http://t.co/fkoZd4bTrj
Timothy Reazor
18 Dec 14 17:35:48
If there is going to be a sustained move higher in $SPY & $QQQ you haven't missed it-here's a video that explains... http://t.co/1mW4csaiXr
Chris Z
18 Dec 14 17:35:23
RT @nanexllc: Classic. The high in $SPY (for the year?) was set by a fat finger + broken markets. You can't make this up
18 Dec 14 17:35:19
RT @etfguide: CHART: Here's why $XLU is +26% YTD vs. the S&P 500's +13% $SPY http://t.co/hKe526sUyt
Perfor Mance
18 Dec 14 17:34:07
Option Millionaires: Vish: $SPY - got over 207 .. jesus christmas http://t.co/zO1IllZ8Tw
Felicia Chen
18 Dec 14 17:33:29
RT @nanexllc: Classic. The high in $SPY (for the year?) was set by a fat finger + broken markets. You can't make this up
David P. Sims
18 Dec 14 17:31:22
$SPY briefly touched $212 this afternoon. Flash spike. No sellers?? http://t.co/2H86XwpHG8
Gene Hobbs
18 Dec 14 17:29:51
RT @YahooFinance: Large daily rallies tend to take place in bear markets http://t.co/ECjqQ7KVuA via @KimbleCharting $SPY http://t.co/6vYx7s…
Blanco Capital
18 Dec 14 17:28:24
The Santa rally. AM/PM. $TSLA $SPY $ES $QQQ $AMZN $GOOGL $NQ $BIDU $PCLN $LNKD $FB $TWTR $baba $nflx $gs $bac $jpm http://t.co/yyLt6ee8mv
Kym L
18 Dec 14 17:27:57
$SPY 15 Min. ummm.... I dunno, maybe 2nd PRZ tgt was hit https://t.co/81j99GNe2Y via http://t.co/xwjHFWIZcr
Options Trader
18 Dec 14 17:27:06
RT @StockTwits: There was a giant "FLASH SPIKE" right before the market closed. Just look at this chart -> http://t.co/xG0os88zk5 $SPY
18 Dec 14 17:26:43
RT @nanexllc: $SPY spike wasn't 1 trade. Or 10, or 100. It was 1,147 trades (610K shares): http://t.co/WpNQsnVJyh
News & Videos
18 Dec 14 17:26:32
$SPY: CNBC: Dissecting the day’s upward momentum and how to play it, with the Fast Money... http://t.co/CW3nIHOjcJ http://t.co/GMd3WNaZ3S
By  +Follow July 3, 2014 7:09AM



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