Few investors could explain the difference between portfolio management and investment management. That’s too bad, really, because there are significant differences.

Investment management is all about buying individual securities without really understanding the impact each security has on the overall portfolio. It is similar to buying bread and ham separately without giving any thought to how the two combined might make a great sandwich, let alone recognizing how a little butter and some lettuce and cheese could substantially enhance it. Unfortunately, investors buy the equivalent of a loaf of bread and a box of dishwasher soap because the concept of putting these things together never cross their minds.

That is fair, however, because it didn’t cross anyone’s mind until 1952, when a University of Chicago student by the name of Harry S. Markowitz challenged conventional wisdom. His doctoral thesis debated whether investments should be kept to themselves or whether one could benefit from a theory that investments interacted with each other.

Putting his theory to work, Markowitz discovered that investments not only don’t work in isolation; they can also turn out higher returns with lower risk when combined in a portfolio. His conclusion, which came to be known as the Modern Portfolio Theory, was that a properly constructed portfolio of individual securities creates synergies through which the output of the combination is greater than the sum of its parts.

The logic is appealing. Yet, in practice, no thought is given to these synergies when most portfolios are constructed. Securities are purchased based on their historical returns rather than on what benefits they may or may not bring to the whole portfolio.

A portfolio, then, should be an intelligently combined collection of securities. Rather than holding a disparate collection of investments, portfolios ought to be constructed within the context of how well new securities fit with the existing holdings. The goal is to ascertain what the inclusion of additional securities will add to the portfolio in terms of return, and what they will do to the portfolio’s risk.

Options can be used from a number of perspectives to enhance a portfolio’s structure.
One perspective is applying leverage within a portfolio context. For instance, if we have constructed an appropriate portfolio, it is, by definition, diversified.

In fact, there may be layers of diversification, including: by asset mix (for example, what percentage you have in stocks and bonds and cash and real estate and alternative strategies); by geographical region (do you have investments outside Canada?); by sector (oil, financial services and consumer durables, for example); and, last, by individual securities (large-cap, mid-cap and small-cap; government bonds and corporate bonds). The interaction of these models defines an expected rate of return for a given level of risk.

If we accept that the portfolio has risk-reduction characteristics, we could apply leverage to some of the assets within the portfolio to enhance its returns — for instance, buying long-term call options on an equity index instead of the index itself. The options would move more dramatically, given a change in the value of the underlying index, which provides the performance bump. That is leverage at work.

Timing is also an issue, although the extent to which it defines what goes into a portfolio is tied to the investor’s time horizon. For someone who is buying a security with an expected payoff measured in months rather than years, timing is an important issue.
For long-term investors, for whom the measuring stick is years rather than months, timing is obviously less of an issue.

Options can also play a role in how you enter a new position within your portfolio. For
example, if you are looking for a short-term expected payoff, buy short-term call options, assuming option premiums are relatively cheap, for your portfolio.

Or, if options are overvalued at a point in time (for instance, high levels on the CBOE volatility index), you could use short-term covered-call writing strategies. The key is a short-term expected payoff with a short-term defined risk pattern. The most you can lose in buying a call is the cost of the call. The covered-call writing analogy effectively reduces the short-term risk associated with a specific security.

Another consideration that arises from the timing debate is where various securities or asset classes are in the business cycle. For example, oil stocks have recently turned in some stellar returns. One could say that, in terms of where they sit in the current cycle or where they are relative to recent history, oil stocks are expensive. But just how expensive depends on whether the individual investor believes that oil is overpriced, fairly priced or undervalued. That judgment call dictates whether or not you would make a new investment in a specific oil stock.

@page_break@Suppose you believe oil should play a role in your portfolio. It may provide sector diversification, but buying oil today may mean buying at a time when prices are high. If you believe that oil stocks are expensive, you could write naked put options on the
stocks that you would be willing to hold in the portfolio.

Thus, with this strategy, you are only forced to buy (because the put is exercised) at a price (the strike price of the put) that you believe is reasonable.

This concept makes sense only for those who believe that the portfolio approach is the right approach. In that light, options can be an important tool to enhance the portfolio experience. Remember that the goal is to bump up performance for a given level of risk or, stated another way, a greater return with less risk. IE