WARNING: The following article provides hypothetical examples of investors just like you.
If I had a dollar for each time a client asked me “How much money are you going to make me?” I wouldn’t be working right now. The question of course, is not the right question for most investors. Before you consider how much money you MIGHT make when you invest I urge all of you to consider how much you WILL lose if your investment gets sour.
This video will provide an idea of how you might want to invest for retirement.
Think back to the tech bubble and the recent financial crisis in 2008. Remember what happened? Retirees were asking:
- How did this happen?
- What do I do?
- How am I supposed to retire?
The fingers were pointed and the blame game began. Fast forward to one of the largest bull markets in history supported NOT by the creation of innovative companies like Microsoft (MSFT) or the invention of the automobile but instead supported by the Federal Reserve who attempted to avoid cataclysmic banking failure and buy time for financial institutions/individuals to regroup – they tried to stimulate the economy.
The Federal Reserve stimulated U.S. stock markets without a doubt, but their quantitative easing programs are now in the books….so the following risks should be acknowledged:
- Each of the last few times the Federal Reserve announced the end of QE programs the stock market nose dived.
- Baby boomers, the largest percent of the population at roughly 25%, reached retirement age and they will likely be withdrawing their 401k’s, IRA’s, and Pensions to live on. They probably will want to invest mostly for income rather than growth since the risks of the stock market could crush their retirement dreams in a hurry. There is a very large chance that the majority of their money will be coming out of the stock market over the next several years.
- The S&P 500 is up over 200% since it’s March 2009 lows (See the chart below) and although anything is possible, my guess is that the next move won’t be 100% higher.
Remember: Don’t just ask your advisor “how much money are we going to make?” Also ask them how much money is at stake- how much can I lose? (hint: this might be an idea of how to invest for retirement).
No matter what the statistics tell us, no matter how bad the economy really is, the market could go higher still. So what do you do? Let’s look at two investors and try to decide which one sounds more like you.
Investor 1 John is 55 and owns the company RaceDingo
John’s advisor uses diversification instead of options to manage risk for John. Simply put, his portfolio contains stocks, bonds, real estate, and commodities (either directly or via mutual funds and etf’s). More specifically John holds about 70% of his money in balanced and equity funds.
Investor 2 Erica is 55 and owns the company Badu Badu.
Erica’s advisor uses options to manage risk . She invests 80% of Erica’s money into a hedged indexed stock portfolio and Long Put contracts to limit her potential losses in case of a stock market crash. Erica and John are looking to retire in 7 years and have $500,000 invested in their respective portfolios.
First I’ll provide the cliff notes, then for detail oriented yootes I’ll dig into the cliff notes.
Since Erica’s advisor uses Long Put contracts to protect her downside risk, she can sleep at night. She knows exactly how much she has at risk if the market rises, falls, or stays in the same place. She has peace of mind. If the S&P 500 drops 50% like it did during the last recession she has insurance in place that will limit her downside losses.
John on the other hand will rely on his bonds for safety…. this didn’t work well in the last recession, in the tech bubble burst, or in most crashes – but his neighbor uses this advisor so he’s trusting his gut. John and his advisor will win if the market continues higher, but if a train wreck happens he will be under the covers praying for a miracle – he promises never to invest without insurance again if the investment gods could get him back to his 500k just one more time.
Below I’ll show you a chart, a table, and finally I’ll add some commentary to help you see the risk reward of each portfolio. Perhaps you’ll recognize John or Erica’s shoes and desperately want a different pair! If so click HERE!
Table assumes bond valuations don’t change. This is not a realistic assumption but the table is trying to show the impact of SPY girations not bond holdings. SPY price columns assume this is the price at expiration.
Some of you will understand the metrics shown in the table above, others will look at it as if you’re trying to execute long division after 6 hours of tailgating at a college football game. For you math geeks you can see how the risk reward works for each investor in the table above. A wordy explanation is listed below. For the non math geeks here’s the explanation.
Erica can sleep at night because she knows she has insurance on her investment.
Meanwhile, John tosses and turns all night wondering how he will survive if the market tumbles.
Erica bought 20 205 strike SPY Puts that expire June 19th of 2015 to protect her $400,000 investment in SPY- think of this like buying insurance on her car or house…in this case it’s her investment. SPY is designed to mirror the S&P 500’s movement. In theory, if the unthinkable but highly probable happens and the S&P 500 drops by 30-50% before June 19th of 2015 – Erica doesn’t have much to worry about.
In fact, (assuming she makes no changes) the most she could lose if markets nose dive is the cost of her insurance less the intrinsic value.
Here’s why. If the market dips 50%, then Erica’s SPY Put would be worth roughly $200,000 and her SPY holdings would be worth roughly $200,000. Including her cash position, Erica’s holdings would still be worth close to $480,000. Erica’s losses amount to single a digit percentage…not bad compared to the 50% pain most equity investors would feel in this situation.
If the S&P 500 increases by 20% her SPY ETF’s should gain about $70,000. Meanwhile if it’s close to June 19th and the S&P 500 is up 20% Erica’s option contracts would be worthless. She would lose the entire $20,000 she paid for the option- (similar to how your car insurance works).
The worst situation for Erica is if the market ends up in the same place June 19th 2015. If this happens she makes no money on her ETF and loses the entire 5% or $20,000 she paid for her insurance (SPY150619P00205000)
While Erica’s big worry through June of next year is 5% of her account, John has all kinds of things to worry about. He doesn’t have any insurance on his portfolio. If the market drops 50% he’s likely to lose $175,000 on his SPY holdings… if interest rates rise at the same time… he could easily lose another $12,000-$60,000 depending on the duration of his bonds. John’s max risk is actually $475,000.
Hopefully you now understand how two very different investment strategies (married put option strategy vs. traditional diversification) would behave in different market cycles and maybe have a new idea on how to invest for retirement.
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This presentation is for informational purposes only and is not INVESTMENT ADVICE, TAX ADVICE, or LEGAL ADVICE. THE INFORMATION IN THIS ARTICLE MAY OR MAY NOT APPLY TO YOUR SPECIFIC SITUATION. CONSULT WITH A FINANCIAL, LEGAL, OR TAX TEAM ABOUT YOUR SPECIFIC SITUATION.
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