By Doug Carey, Atlas Capital Management
After the stock market collapse in 2008 and 2009 many investors are understandably skittish about investing in equities again. Some have decided to wade back into the stock market, but are demanding some form
of insurance against catastrophe. The fear of losing over half of one’s investments is enough to keep people up at night. Because of this fear, the idea of portfolio insurance has once again become a popular topic. For some this is a good idea, but there are several pitfalls and bad deals out there today.
A put option gives the buyer the right to sell a stock, stock index, or Exchange Traded Fund (ETF) to the put seller at a specified strike price. The put option buyer will make money on his put if the stock price falls by enough to offset the cost of the put itself. Example: An investor owns a great deal of Microsoft stock (MSFT) and wants to insure against any drastic declines in the stock price. More specifically, he can only handle a loss of 25%. So he buys a put option on MSFT, which is currently trading near $27 a share, has a strike price of $20, and expires in a year. If the stock price falls to $20 or lower the put buyer can “put” or sell the stock to the seller for $20 a share. Let’s assume the buyer owns 10,000 shares ($270,000 worth) of MSFT. The cost of a put on 100 shares of MSFT as of today is about $45. So to hedge against 10,000 shares it will cost the buyer $4,500 per year. Looked at another way, it costs the buyer 1.7% per year to insure against a loss of 20% or more. Over ten years, this type of insurance will deduct over 18% from the overall value of the MSFT holdings.
Whether or not this type of insurance is worth the cost really depends on how stressed out the owner is about the stock price falling. If the owner really wants to hold the stock, but simply cannot sleep at night because of his fears about the stock price tanking, then a put option might be a smart move. However, it is important to note that there are a few drawbacks to this type of transaction. First, the fees and transaction costs to buy a put option are very high. This can increase the cost of insurance by several thousand dollars. Lastly, you have to know what you’re doing. Buying various types of put options can become complicated and there are many choices with regards to options expiration and strike prices.
Stock Index Annuities
An annuity is a contract in which an insurance company makes periodic payments to the holder. Some annuities have guaranteed rates of return (fixed annuities) and others offer a chance of higher returns along with a chance of loss (variable annuities). Stock index annuities offer a minimum base return with the potential to achieve a higher return if a stock index, such as the S&P 500, has a good year. This sounds like a great deal, right? But if something sounds too good to be true, you can bet it is.
Index annuities can be very difficult to understand. There can be so many rules that even a savvy investor cannot decipher how the contract will pay in various events. For example, some index annuities offer a low guaranteed return of 1% that applies to only a portion of the portfolio. Then if the index rises by more than a specified percentage, the owner only gets a portion of that gain. Also, very large fees can kick in if the index rises or falls by a certain amount. These annuities are overly complex by design and many of the convoluted rules are buried in the fine print. The goal is to sell something that isn’t as beneficial as advertised.
Given this, it’s best to stay away from equity index annuities altogether.
What Else Can be Done?
If an everyday investor does not want to get involved with put options and wisely stays away from index annuities, what else can he or she do? Basically we’re back to the tried and true idea of limiting risk by diversifying investments and not taking on any more risk than you can handle. It’s very important that investors understand their time horizon in terms of when they will need the money in their portfolios. It is also important to understand that diversifying risk doesn’t mean owning a U.S. stock fund that invests in 300 different stocks. As we’ve seen, when the market crashes most U.S. stocks crash together. Diversifying means potentially owning U.S. stocks, bonds, emerging market investments, commodities, gold, and real estate, to name just a few ideas.
Doug Carey is a Chartered Financial Analyst and owner of Atlas Capital Management, a wealth management company based in Boulder. His company provides investment management and financial planning services.