In the last sections, you learned the basic concepts, risks and benefits associated with an IOP. This section should whet your appetite in a few key areas of investing that are improved through the use of an IOP. Let’s begin with inflation and deflation.

 

Inflation/Deflation

These two animals are the silent destroyers of many financial plans.  They have been mostly tame over the last 150+ years in this country, but both are now knocking at our doors.  In fact, deflation has already come in through the door and poses the most urgent threat.  It devastated the world during the Great Depression and is currently causing much grief and turmoil.

On the other hand, there is a very real threat that the large scale actions by the Federal Reserve and lawmakers in the U.S. may bring about serious inflation on a scale that has not been experienced in this country since its early days.

We should clarify that there are two types of inflation that we see as a threat.

 

First, we are talking about the “rate of fall” (of the value of the dollar) when we are talking about a steady decrease in the dollar’s purchasing value.  Anything that the U.S. has seen in the last 100 years, we would place in this category.

Second, we are talking about very rapid adjustments to the purchasing power of the dollar or an “already fallen” dollar.  This happens very rapidly and usually without much warning.  It comes about when governments increase the money supply rapidly and the markets finally catch on.  While someone in shorter term CD’s or TIPS could adjust partially to a high “rate of fall”, by earning interest at the new higher rates, rapid adjustments diminish purchasing power before there is any time to earn interest.

At Desert Rose, we are not doom and gloom people.  We are not saying that any of the above scenarios will take place and we hope that they don’t.  We don’t pretend to be able to know just what will happen, but we can prepare as best we know how, while continuing to strive to make more money with less risk in the meantime.  We kill two or three birds with one stone, so to speak.  We chuckle when we hear the solutions that some of the news pundits put forth to solve these two threats of inflation and deflation, not because they’re stupid, but because what we do here at Desert Rose is so much better.

Let’s look at some current “solutions”.

What would most people consider to be a good asset class to take on normal rates of inflation? That’s right, real property and assets (commodities like gold, stocks, real estate, etc.) that would adjust over time as well as bond type investments that could also keep pace.

Now, how do most deal with serious inflation, the rapid adjustments?  The only thing is real property and assets (commodities like gold, stocks, real estate, etc.) or owning assets in another currency (assuming the other currency is not falling quickly as well).  These assets adjust to the current conditions once they are known.  Think about it, if you own shares of a bread business and inflation suddenly causes the price of bread to shoot up to $10 a loaf, the bread company could make the adjustment immediately and then be able to pay down previous debt using inflated dollars.  The intermittent turmoil could cause some havoc, but it would still be a pretty good hedge.

What about deflation, what do most people recommend?  They recommend the exact opposite.  Cash, income paying investments like bonds, etc.  Whatever asset you buy now will just be worth less tomorrow.

So unless you have a crystal ball to know whether it will be inflation or deflation, you can flip a coin and position the portfolio accordingly, or you can do what many pundits say and split the difference.  This means that you will be right and wrong, with only half the money being positioned correctly in either case.  That’s a poor solution in our opinion.

Two birds with one stone

We can be much better positioned for both inflation and deflation when we use an Integrated Options Portfolio.  We first choose an asset that would position the client for inflation, it could be stock funds (foreign and domestic), REIT ETF’s, Gold ETF’s, etc.  Rather than buying the shares directly, we buy an option on the same shares at a fraction of the cost.  We then take the difference and purchase a great tool for deflation, fixed income.  Let’s use the example from the ”IOP 101″ section.  As illustrated, this structure performs better regardless of the direction of the shares of the main asset.  Since we have $50,000 and want to purchase options on $50,000 worth of the underlying asset’s shares, we will have a long position for 100% of our initial amount.  This means that the $50k is fully positioned for inflation.

At the same time, only $6,500 is needed for the options, which means that $43,500 is diversified away from “ABC” Fund in an asset (bonds) that is great for deflation.

When you look at the results, deflation is covered very well (87% of portfolio), and inflation is covered as if everything were positioned for inflation.

Two birds, one stone, and it’s positioned beautifully for normal inflationary environments as well.

Income

When you are planning for the income needs of a client during retirement, the need for that income to last throughout their client’s life is paramount.  One of retiree’s biggest fears is that they will run out of money during retirement.  While living longer is a great thing, it also poses a challenge for advisors.

As part of their plan, many planners will place their clients into a 40/60 stock/bond portfolio to be able to weather the major financial storms.  They do this because of the reduced volatility that normally accompanies bonds. This leaves smaller amounts to place into stocks, which help provide potential growth, a hedge against inflation and diversification.  Under this model, many planners advise their clients not to withdraw more than 3-4% of the portfolio each year.  Although some may go as high as 5%, advisors are extra cautious to ensure that their clients do not end up running out of money.

How does Desert Rose help?

First of all, because of the characteristics of the IOP, we believe that your clients will have much more to begin with when they go into retirement because our models have the potential to improve the returns of what is owned in the portfolio, even as risk is simultaneously reduced.

Second, because of the decreased likelihood of severe drops in a client’s account value when they are positioned in an IOP, clients can more easily recover from downturns in the market.  This allows them to maintain larger “virtual” stock positions to be able to profit more in bull markets.  We say, ”virtual”, because we own options on more shares of stock, which have the potential to profit in much the same way as owning the same number of shares directly when the stock fund’s price increases.  We don’t actually own the shares and only pay a small fraction of what it would cost to own those shares, so in reality, we have a very small exposure to the stock price in bear markets.  This gives us more potential growth which means more income, yet similar or even lower risk.

The following pie charts compare the proportions of assets.  The first chart shows an asset allocation that many direct ownership type asset managers might recommend for someone nearing retirement.  The second is the “Virtual IOP”, which demonstrates the equivalent position that would have to be taken in a direct ownership method in order to profit similar to an IOP in flat or bull markets.  The last chart gives us the actual makeup of the portfolio, which tells us how the IOP will perform in bear markets.  Notice that most of the portfolio is in what most professionals would consider to be more stable assets.

Third, when a limited upside of 20-30% is not an issue, we can modify the IOP to produce more income and lower risk even further.  It actually works better than the standard IOP in sideways or down markets, but the tradeoff is limited upside.  Call for more information on this topic.

Bottom line: Our models show that 6% withdrawals are still very conservative.  If your clients can enter retirement with more money and have a higher withdrawal rate, they’re going to have a lot more income.  Merely taking an existing withdrawal rate from 4% to 6% increases the client’s income by 50%!

More AUM (assets under management)

Think about what the last section means to you and what it means in the lives of your clients.  A better lifestyle, less stress about the economy and their futures (fewer phone calls to you wondering if they should change things again) and more referrals for your business.  Think about how this affects your client presentations when you are up against another advisor.  When you can get 50% more income than the other guy, who are they going to pick to manage their accounts?

Along these same lines, the volatility in the market has created a lot of fence sitters that know that being in the market is a good place to be for a hedge against inflation, but they are too concerned about current conditions to act on that knowledge.  These people’s purchasing power could diminish greatly from inflation if their money is left in bank CD’s paying them next to nothing.  How many people lost out in 2009 and 2010 because they were parked in a 1.5% CD?

Many of these people could do well with the more conservative versions of an IOP.  The possibilities are many and vary based on each situation.  Contact us for a specific case.

The Do-It-Yourself Investors

This is another class of potential clients.  They have read books and articles on investing and believe they are able to put together a portfolio just as well as anyone.  They don’t see why they should pay an advisor anything, since they can get the same funds as anyone else.  While we know a good advisor’s counsel is more valuable than his fee, the do-it-yourself guys don’t understand that yet, or haven’t found the right advisor.

An IOP helps them to see real value.  When we can help them make more after paying us than they would on their own, with less risk and less hassle, you’ll have a new client.  When they see the other services that you bring to the table, you’ll have a loyal client.  What we do here at Desert Rose Capital Management is exciting.  It’s not talked about in the news or written in a book in the investment section of Barnes and Noble.  It’s not a gimmick or just the results of a lucky streak by a stock picker.  It is professional money management.  It requires extensive knowledge and experience in the markets, specialized computer modeling, a deep understanding of financial planning, taxes and more.  The IOP is not a do-it-yourself technique and they recognize that, enjoy being involved and love to talk to their friends and coworkers about what we have.

Changing Market Conditions

A dilemma that faces most money managers is how to react when the investments that they own have made large gains or when they have dropped significantly.  There are many theories that we won’t get into here, but keep in mind that these are emotionally charged decisions.  If he sells after a large gain and the stock continues to rise, he’ll kick himself for not staying in it.  If he doesn’t sell and it goes down, he’ll kick himself, because he just “knew” that it would go down.

The same is true after a large loss.  If he doesn’t buy more or hang onto the shares, he will kick himself when it goes back up again.  If he does buy more, Murphy’s Law of investing says that it will drop further.

The fact is that no one knows for sure what will happen next, especially short term.  While we don’t try to time the market, we can adjust the IOP to set limits on the amount of money exposed to that same stock as the stock makes large moves.

Summary

At Desert Rose, we don’t just allocate portfolios based on predictions or even just good allocation models.  We create customized portfolios that utilize the power of an Integrated Options Portfolio.  These portfolios are designed to create more money and income with less risk.

The peace of mind that comes to both the clients and their advisors is significant and refreshing.  In a world filled with financial advisors around every corner that offer virtually the same services, an IOP really sets you a few notches above the competition.

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