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A market-beating strategy you should never, ever attempt

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A widely praised speech by a Governor of the U.S. Federal Reserve Board outlined an investment strategy that will outperform the index nine times out of ten. But there's a catch – the one time the strategy doesn't work, the portfolio would be completely wiped out. Extended to the banking sector, the discussion underscored exactly what went wrong during the financial crisis and the complexity of the modern, credit-heavy investment environment.

Jeremy C. Stein is a Harvard economist and member of the Board of Governors of the U.S. Federal Reserve. In a recent speech, Mr. Stein highlighted an investment approach almost guaranteed to beat the index under normal circumstances:

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if you hire an agent to manage your equity portfolio, and compensate the agent based on performance relative to the S&P 500, the agent can beat the benchmark simply by holding the S&P 500 and stealthily writing puts against it.

By holding an index in ETF form, and generating excess profits from selling out of the money put options, it is easy to see how this strategy would normally beat any benchmark. But in years like 2008, the put options would open the investor to near-limitless losses that would crush the portfolio, erasing previous gains and creating new, huge losses.

Mr. Stein is using this example as a metaphor, a cautionary tale of how potential losses can be hard to identify when complex strategies are applied. It goes without saying that investors should never, ever do this in any kind of scale. (Writing covered calls is a different story – the loss is limited to having the stock taken away by the option holder).

The financial crisis illustrated how Mr. Stein's example can be used to explain how the U.S. housing market almost caused the downfall of the global banking system. The U.S. banks made oceans of profits before 2007 by creating giant portfolios of mortgages. The embedded put option for the banks was the physical housing stock that the bank would own in the event of default and foreclosure. When home prices collapsed, mortgage holders owned both worthless mortgages and homes with declining value.

In trader parlance, banks and other mortgage holders before the crisis were "leveraged long" – owning both an asset and derivatives (mortgages and mortgage-backed securities) written on the asset. (This is also jokingly referred to as the Texas Hedge – long the stock and long the calls or, in other words, not hedged at all). The banking system is still in the process of absorbing the cost of either unwinding these positions or writing off multi-billion dollar losses.

Stein's lesson is that while credit and derivatives have created huge economic benefits – consider the consumption boost from easily-available credit cards as just one example – the liabilities, or "bag holders," are often hidden. Investors should keep it simple whenever possible, avoiding structured product and derivatives and holding assets outright.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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