A Way To Invest In The Stock Markets At Record Highs Without Getting Your Face Ripped Off

Sleepy Bear by Financial SamuraiThere’s only one thing worse than buying a stock that’s going down that continues to go down after purchase and that’s buying a stock that’s going up that ends up going down soon after purchase! A lot of retail investors are wondering whether NOW is the time to jump back in with major US indices at record highs.

Between the recovery years of 2010-2012 there was a net cash outflow of $360 billion dollars in US Stock Funds according to Investment Company Institute. Year to date there has been roughly $41 billion in net cash inflows. It’s the classic “day late and a dollar short” herd mentality that we see over and over again.

I’m personally very hesitant about chasing the markets here and have taken some profits in my 401k. That said, I also hate missing out on a potential “too the moon” scenario where stocks continue to percolate higher. Stocks generally always overshoot on the upside and downside thanks to greed and fear.

So what is a late and greedy investor supposed to do in this environment? Hedge of course!

A WAY TO LIMIT RISK WHILE BUYING STOCKS AT RECORD HIGHS

Take a moment to study the chart of a four year term Dow Jones structured note below. The chart says that you get 100% of your money back if the the structured note closes between 0% to -10% during the duration of the note. Anything beyond a 10% decline and you start suffering a 1-for-1 decline + the 10% buffer. In other words, if the Dow declines 15% over the next four years you lose only 5%.

On the positive side, if the Dow Jones gains anywhere between 0.1% and 20% over a four year period, you get a 20% return on your money. If the Dow Jones gains more than 20% you participate  in 100% of the upside.

Hedging-A-Purchase

This structured derivative is perfect for someone who wants some downside protection while participating almost fully in any further upside. The Dow is roughly at 14,500 today. Only after the Dow Jones breaks below 13,050 will the investor start losing money on paper. There’s also a reasonable chance over the next four years that even if the DJIA breaks below 13,050 it will recover above 13,050 to provide the investor with at least a return of all their capital.

The downside of purchasing such an investment is a four year lockup period and the loss of annual dividend payments that equates to roughly a 2% yield a year.

SO WHERE CAN YOU PURCHASE SUCH AN INSTRUMENT?

This particular structured note is through Citibank. However, I spent some time talking to a Wells Fargo and JPM Chase personal banker and they also offer such products. The only hurdle for some is that you need investable liquid assets of usually $100,000 (Citibank) to $1 million (JPM Chase) minimum in order to invest. Perhaps this is one of the reasons why the general public doesn’t feel wealthy with stocks at record highs. Exclusion.

The other way to create a similar structure is by building your own derivative portfolio with your online broker with no apparent minimums. I know E*Trade and Fidelity (where I have assets) can help build such a structure, and I’m sure other platforms can as well. You can simply ask your representative to put together something similar for you.

The whole idea is to give up a little bit of upside to provide a downside buffer in case your timing is terrible. You know, like buying stocks right before a bank run in Cyprus thanks to its new 7-10% tax on bank deposits in order to qualify for EU bailout money!

OVERCOMING FEAR

As a value investor, I loathe to purchase anything after a run-up. The major US indices are trading at roughly 17X estimated earnings (DJIA 14,500, S&P500 1,560). That’s not egregious based on historical valuations. I just don’t have the confidence to put fresh money to work without some sort of protection. At the same time, we are experiencing unbridled bullishness in the economy that could easily carry us much higher until we implode again.

Finding some downside protection gave me the courage in June 2012 to dump a large chunk of change into the markets when the Dow was at 12,000. The greedy investor in me wants as much exposure to the upswing as possible. Yet, the retiree in me wants to protect my nest egg at all costs.

WEALTH BUILDING RECOMMENDATION:

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Photo: Do not wake the sleepy bear, 2013, FS.

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    I wouldn’t be surprised if the market jumped all over the place in the next few years, especially if we get some more bad news out of Europe. From the looks of things, the markets are now ignoring any new bouts of Congressional idiocy.

    Time is my hedge. Since my focus is on dividend growth stocks and my ideal holding period is forever, I’m not too concerned with the short term market gyrations. My account might drop in value on paper, but so long as my stocks keep cranking out their dividends, I’m happy.

    The one thing that does worry me is adverse material changes in companies like what happened when the finance sector tanked in 2008. Both the stock value and the dividends got cut. The only real hedge against this is making sure that I have a diversified portfolio of companies and sectors. I’m still not where I want to be diversity-wise, but I’m working towards it.

    While I find structured notes interesting, there are ways for people with less available money to hedge against downside risk. Trailing stop loss orders and certain options trades come to mind.

  2. says

    I agree the market is high – Shiller PE or PE10 is at 23.5.

    I also think your idea of creating a derivative portfolio is intriguing, but like everything else it comes at a cost. What is the typical cost to hedge the S&P500 as you describe for 1 year?

    • says

      Depends on how big your portfolio is and how much you’d like to hedge out. You can buy a single index out worth 20% of your long portfolio for very cheap. The costs are not noticeable.

  3. says

    I try to think long (25-30 years) term when it comes to investing. It is good I do not need my nest egg to live in retirement because I think the market will be volatile for a indeterminate time. I will keep on dollar cost averaging into the market for the next 4+ years. I may feel very differently after I retire though.

  4. JayCeezy says

    Very interesting concept, when it all works it looks like a winner. 120% of 1560 is 1,872. I’m not seeing it. FS, you can always go back to work with a great skillset and rep. MFIJ has time as a hedge, and it is a pretty good one. krantcents has a public pension coming, also a pretty good hedge while increasing the nest egg.Reminds me of a great saying, though…

    “All battle plans go to hell, two minutes after the shooting starts.” – Gen. George S. Patton

    On paper, all the things that went wrong in the past 5 years (100s of banks collapsing, Fannie Mae and Freddie Mac requiring bailouts, USPS requiring constant life-support, IMF Global billions ‘disappeared’, ZIRP for 7 years and counting, no Federal budget passed for 4 years, government pension programs at all levels cratering in the outyears, Enron, Countrywide, Bear Stearns, Indymac, subprime bundles, TBTF, Solyndra and “green” business corruption, systemic un/underemployment, etc.) all looked pretty good.

    For me, I have built and lost one nut already. I’m like a batter that gets hit-by-pitch, and then keeps stepping in the bucket. I’m on the PF subway looking for my exit, but the train just keeps on going through bad neighborhoods.

    OK, enough metaphors. I’m still moving out of equities, and into CDs varying in duration from 6 months to 10 years. When interest rates normalize, a Federal budget is passed, unemployment stabilizes, I will assume my own risk of missing out on equity upside. I actually hope I am wrong, and you all make tons of dough! It will be a very good sign if that happens.

    • says

      A 20% increase in the US stock markets in four years doesn’t seem that far fetched. The biggest winner of such a structure is someone who believes the Dow goes nowhere 0-5% over the next four years and therefore gets a 20% return.

      I like how there is 100% participation if the market just rips higher.

  5. says

    I tend to sell put options on stocks rather than buy them outright when valuations are at these levels. It can be done with some ETFs as well, for those that don’t buy individual stocks.

    It sacrifices some potential upside until expiration, but generates decent returns in a flat market and reduces the cost basis of an investment if the market drops.

  6. Worryfreefinance says

    FS,
    Long time reader, first time responder….
    it will be great if u can write a post about creating your own structured derivatives with a smaller amount. The devil is in the detail. Without that detail your post is as valuable as msnbc talking heads. :-(

    • says

      You might be missing the point of the post. Are you really after the inner workings of how a car works rather than it’s ability to take you to your destination? Expand your mind and share with use how you see the markets and hedge. Don’t be afraid.

      • Worryfreefinance says

        The way i read ur post. Car costs 100k but u can build ur own for 25k. Now go figure out how to build it. Its probably a very straight answer for smart people like you but i don’t know how to build this hedged engine of growth.
        Msnbc talking heads wasn’t meant as a snide comment. My point is I expect better from good quality blogs like yours. If I just wanted “ideas” I could listen to msnbc.

        • says

          The cost is less than a couple percent and the returns are net of fees.

          I expect my readers to come with substance if they are going to comment. I dont mind snide remarks. Just have something intellegint to say. Thinking there is a 300% markup on costs (25k but sell for 100k) makes me lose faith in readers. What is your background?

        • Worryfreefinance says

          I wasn’t trying to say there is a markup. Simple question: how do you build a strctured note using a brokerage account? I.e. how do ppl with smaller investments build such instruments? Hope this is clearer.

  7. says

    Curious what sort of fees you pay on a product like this. I like the idea of having a great upside capture ratio on an investment but you also have to remember that these have low liquidity and are tied to the banks you invest with. TBTF won’t allow banks to fail but I don’t trust them for that long. See JPM stories this week as a good example. Here’s a Forbes article on the risks invovled in structured notes: http://www.forbes.com/sites/greatspeculations/2012/11/30/structured-notes-buyers-be-warned/

    Always good to see both sides of every trade/investment.

    • says

      Good find. Not sure if “they could lose you money” and “liquidity” are anything out of the ordinary as risks. There are no sure things in any investment except for CDs under $250k for individuals and Treasuries IF you old to maturity. Definitely a good idea to seek the biggest bank as well to reduce solvency risk. If Citibank and others didn’t go under in 2009, it’s hard to imagine any of them going under.

      The cost is baked into the price of the returns.

  8. says

    I took some profits recently and am trying to decide what I want to do next with my money. It would be nice to just sit back and hold cash, but that just doesn’t make much sense with interest rates so low. I’m only getting a measly 0.15% right now. I certainly hope the markets will continue to strengthen but I think there is more correcting to come. That’s crazy about Cyprus! I don’t blame people for going on bank runs with those kind of taxes. Love your pic btw!

  9. says

    Good post, I hate getting my face ripped off, especially when I’m the guy doing the ripping by making a bad investment. I’m exactly where your are with the market. I’ve taken some money off the table but also don’t want to miss a potential run. I use trailing stop losses to help with that. I posted an article recently on the stop loss, http://wisedollar.org/investing-in-stocks-and-the-stop-loss/ , I hope you don’t mind if I included the link here. As the market continues to rise, I tighten up the stop losses on the positions that have them. Not trying to find the top, just trying to get close! I haven’t really looked at structured derivatives before, you’ve opened my eyes a bit on this one. It definitely gives you some upside while limiting your risk, I like that!

  10. says

    Great Post and very interesting concept. I’m a skeptic though. It seems too good? Has it existed in the past has such a plan worked in 2008? Is is guaranteed?
    I’m closing in on retirement, keeping fully invested mostly with high dividend stocks. My experience during the last down turn is that dividend stocks took less of a pounding. Of course every downturn is different. I don’t invest more than 4% of portfolio in any individual stock.
    I like the earlier comment about time being the hedge. If the market averages 7-10% return over long run why not stay invested?
    If you are comfortable with the risk you look at it not like ‘getting your face ripped off” but like “here’s the storm now let’s safely navigate till it’s past.”

  11. says

    @ Untemplater
    Untemplater, I too locked in some increases, using a trailing stop loss order. I may just do the same again, since I reinvested in the same stocks although slightly above (about $0.75 above) the level that the trailing stop loss order was exercised for.
    Well, since they are well paying dividend stocks I will most likely leave them ride for a while longer.

  12. Shaun says

    Interesting idea, where you lose out is definitely the 4 year lockup period. Even if you had the foresight to buy pre-2008 crash you would still end up in roughly / the same place as somebody invested in the market the whole time by 2012. Wonder if it usually works out that way and somebody figured out that at a 4 year window the bank is unlikely to lose.

  13. Rob says

    FS,

    I may be missing something, but what does the bank have to gain from providing this sort of structured note? If you lose money, you have a 10% buffer, and if you gain less than 20%, you still get the 20% gain. It seems like the bank would only break even if you the Dow gains >20%. The fees for something like this must be astronomical to account for their risk.

    • says

      They gain by taking your money and investing it for the next four years (or whatever duration they have to structure). Banks easily hedge out their risk and make a spread profit. You also give up your dividends with this note.

  14. Matt says

    Sam,

    Why not play the riskiest part of the market (small value) with an amount of money that would return the total market average?

    I.e. if small value expected return is 12.5% and the market average is 8.2%, why not invest $960 in small value that would get the same expected return as $1,000 in the total market.

  15. Thomas says

    A good read. I guess investing in stock markets is very ambiguous. With the constant ups and downs that most of us have encountered, this has made us jittery about investing in stock markets. However, we should be aware how our personal investments of today will be our future income and hence knowing the right investments is a must.

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