I’m always looking for new investment ideas due to excess cash flow. All of you who spend less than you make should have the same problem. But given we are near all-time highs in the stock market, good ideas are harder to come by.
I’m also always being asked by folks who discover my background whether I have any investment ideas for them. I usually play dumb so I can live a more peaceful life. Besides, everybody’s financial situation and risk tolerance is different.
For the sake of growing our knowledge, I’m going to do something different from now on. Every time I stumble across a good investment idea where I plan to invest a significant amount of capital ($10,000+), I’ll write about it if allowed. I’ll lay out my bullish argument and the FS community can proceed to tear it up. The community will get to learn how to analyze similar investment ideas in the future so we can all get smarter.
The Easiest Investment Ideas
Before we talk about my latest investment idea, let me remind everyone about a perennially good idea: paying down debt, no matter how low the interest rate. After all, a small positive return is better than a loss if the markets correct. Not once have I regretted paying down debt. Even if the money I put towards debt could have made more money in an investment, I’m happy reducing debt.
Another great idea is to invest in your business or yourself. There’s a good chance with additional capital expenditure your business or career will grow faster than the market. For example, Financial Samurai was a triple digit grower for the first five years, easily crushing the returns of the market. Getting an MBA part-time to invest in my career also paid off due to a promotion the year I graduated. Do not underestimate the power of you.
If you’ve already developed a steady debt pay down strategy and you’re already spending wisely on yourself or business, here’s one of my investment ideas that might intrigue you. This article is relevant for those who:
- Are afraid of investing in the stock market at all-time highs
- Want to know how to invest in hedged investments
- Invest for the long term
- Feel they have too much cash
Overcoming The Fear Of Investing
Despite the fees (0.5% – 2%), I’m a fan of structured notes. Many of them provide a downside buffer or barrier in a particular investment plus full upside participation. Back in 2012, I didn’t have the courage to invest $150,000 of my severance check into the stock market because I had no job. But I felt strongly then, as I do now, that it’s important to continuously invest for the long run, no matter what your situation.
What gave me the courage to invest back then was a principal protected structured note. In other words, no matter what happens over the six-year note term, I can get 100% of my money back provided the issuing bank is still in business. If the market went up 100% during this time period, I’d also be up 100%.
What was the catch? The minimum investment amount was $50,000. And I would only receive a 0.5% annual dividend versus a 2% annual dividend if I had bought a DJIA index ETF naked (no protection) instead. The issuing bank would also get to use my money as they pleased.
It’s been over four years since I bought the note, and it’s annualized an ~8.8% return net of fees. I took $53,000 in profits off the table in August for some home improvement projects. There was no penalty for selling a portion of my note early either. Although they usually charge a 1% fee. My banker forgot to tell me before I sold, so he waived the charge. I’m letting the remaining $150,000 principal balance ride until the note expires.
See: Practice Taking Profits To Pay For Life
Utilize Investment Ideas That Offer Downside Protection
There is no way I would have gone “all-in” if there wasn’t any downside protection. I’ve since invested in many more structured notes since 2012 to overcome my fear of investing in the stock market. When you’ve invested through the Russian Ruble Crisis, the Asian Financial Crisis, the dotcom bomb, SARs, and the US housing implosion, you have a lot of battle scars.
When you retire early or set out to become an entrepreneur, the desire for cash is more intense.
For those of you who are also concerned about going naked long when the stock market is at its all-time high, take a look at the below investment.
Investment Ideas At The Top Of The Market
Here’s an example of a structured note that can be a good investment idea in a bull market. First, study the chart and see if you can understand what this note is offering. We’ll then discuss the terms in detail below.
Terms Of The Structured Note
Underlying Security: S&P 500 Index (as plain vanilla as it gets)
Barrier: 30% (won’t lose money so long as the S&P 500 doesn’t decline by more than 30% on the date the note expires)
Participation Upside: 150% uncapped (1.5X the return at maturity net of fees)
Dividend: None (miss out on the 2-2.5% S&P 500’s annual dividend)
Maturity: Sept 2021 (5 years)
Fee: half a percent e.g. invest $1,000, $5 goes to the bank.
Example 1—Upside Scenario
The hypothetical final index level is 2,296.35 (an approximately 5.00% increase from the hypothetical initial index level), which is greater than the hypothetical initial index level.
Payment at maturity per security = $1,000 + the leveraged return amount = $1,000 + ($1,000 × the index percent increase × the leverage factor) = $1,000 + ($1,000 × 5.00% × 150.00%) = $1,000 + $75.00 = $1,075.00
Because the underlying index appreciated from the hypothetical initial index level to the hypothetical final index level, your payment at maturity in this scenario would be equal to the $1,000 stated principal amount per security plus the leveraged return amount, or $1,075.00 per security.
Example 2—Par Scenario
The hypothetical final index level is 2,077.65 (an approximately 5.00% decrease from the hypothetical initial index level), which is less than the hypothetical initial index level but greater than the hypothetical barrier level.
Payment at maturity per security = $1,000 Because the underlying index did not depreciate from the hypothetical initial index level to the hypothetical final index level by more than 30.00%, your payment at maturity in this scenario would be equal to the $1,000 stated principal amount per security.
Example 3—Downside Scenario
The hypothetical final index level is 656.10 (an approximately 70.00% decrease from the hypothetical initial index level), which is less than the hypothetical barrier level.
Payment at maturity per security = $1,000 × the index performance factor = $1,000 × 30.00% = $300.00.
Because the underlying index depreciated from the hypothetical initial index level to the hypothetical final index level by more than 30.00%, the contingent repayment of the stated principal amount at maturity would not apply.
Financial Analysis
When I first saw this note I wanted to immediately invest $200,000, or ~70% of my liquidity (but less than a 5% position in investable assets). To be able to get 150% of the upside sounds so good. Let’s say the S&P 500 is up 40% in five years. Instead of being up $80,000, I’d be up $120,000. Meanwhile, with a 30% barrier, the chances of losing money drastically declines.
From the S&P 500’s peak in 2007 to its low on Feb 1, 2009, it saw a decline of 51%. I doubt we’ll see such a hammering if a bear market returns due to much more stringent lending standards over the past seven years. Banks and individuals are less levered, and more control mechanisms are in place.
Bear Scenario
If the bear scenario occurs, I assign a 20% probability the S&P 500 will decline by over 30% when the note comes due. The S&P 500 could decline by 90% during the five year time period but you’ll still get your money back so long as the S&P 500 rallies upon expiration and is only down 30% or less. If the S&P 500 is positive upon expiration, then you get 1.5X the return.
Given this is a barrier note and not a buffer note, if the S&P 500 declines by more than 30% when the note expires, you’ll lose exactly the amount the index declines. If this was a buffer note, then your downside would be helped by the buffer e.g. if the index is down 50%, your actual return will be down 20% because you’d have a 30% buffer.
Bull Scenario
In the bull scenario, it’s important to compare new potential investment returns to the risk-free rate of return. Everybody can buy a 5-year CD yielding 2% today. After five years, your CD investment will have returned a guaranteed 10.4%, which I will assign as the bull scenario break even point. The more you believe the S&P 500 will be up 7% or greater after five years, the more it makes sense to invest in this note given the 1.5X kicker (7% X 150% = 10.5%).
If the S&P 500 goes up by 4% a year for five years, the S&P 500 will have returned 21.6% excluding dividends, and you will have returned 32.4% from this note. Even if the S&P 500 goes up by only 3% a year for five years, the S&P 500 will have returned 15.9% excluding dividends. Your total return would be 23.85% with this note.
Of course, bad things can happen within these five years as well. We could have a recession and the market actually goes down. There could be another international debt crisis that brings the world to its knees. Who knows for sure. There are always risks involved with investment ideas, even ones that seem foolproof.
The stock market feels like it’s being artificially propped up by low interest rates. The Fed will most likely continue to raise the Fed Funds rate several times during this five-year period, creating headwinds for stock market performance.
I assign a 60% chance the S&P 500 will be 10.4% higher in five years.
Adding both scenarios leaves me with 20% to assign to a par scenario where the S&P 500 is up less than 10.4% or is down by no more than 30% in five years time.
You may want to invest in this note if:
- You are bullish on the stock market, but not bullish enough to go naked long.
- You’re not in need of more investment income. The 1.5X kicker will help make up for lost dividends if the S&P 500 return is positive in five years.
- You are looking for a hedge because you feel there’s a chance there will be a downturn over the next five years, but you still want equities exposure in your net worth.
- You’re outlook is long-term and you don’t mind locking up money for five years.
- * You have cash sitting in your IRA that can’t be touched until 59.5.
Final Decision: I ended up investing a total of $200,000 in this structured note. $50,000 in my after-tax account and $150,000 in my rollover IRA.
So Many Ways To Invest
Fear of losing money is the biggest reason why people don’t execute their investment ideas. Low cost wealth managers like Personal Capital help reduce such fears. They can help you build, invest, and rebalance a risk-adjusted portfolio for you in public securities.
If you have more than $100,000 – $250,000 to invest, many big banks such as JP Morgan Chase and Citibank offer alternative investments to their private clients. These investment ideas help protect principal while also providing 100% or greater participation on the upside.
As someone who is neutral on the stock market after such a long bull run, investing in a note that provides a 30% barrier and a 1.5X upside kicker is really attractive. I have no delusions that my forecast for a soft market could be dead wrong. Let’s hope we have an amazing 12-year bull market that makes us all mega rich! You just never really know, which is why we all must diversify.
Once you’ve amassed a comfortable financial nut to live off, you need to find ways to protect your nut in case of a downturn. Some great protection methods include earning passive income, consulting part-time, earning online income, and working the gig economy. Or, you can simply invest in a security that has a built-in hedge.
More Recommendations
Real Estate Crowdsourcing Investing Ideas
Looking for new investment ideas? Explore real estate crowdfunding. If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns.
Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Track Your Finances In One Place
In order to optimize your finances, you’ve first got to track your finances. Sign up for Personal Capital’s free financial tools. You can track your net worth, analyze your investment portfolios for excessive fees, and run your financials through their fantastic Retirement Planning Calculator.
People who are on top of their finances build much greater wealth longer term than those who don’t. I’ve used Personal Capital since 2012 and have seen my net worth skyrocket. It’s the best free financial app out there to manage your money.
Updated for 2021 and beyond.
Sam,
I would like to share a thought regarding options here that many investors choose to ignore because the media try to portrait that as weapons of mass destruction of wealth. It is nothing further from the truth if one knows how to use the tool.
You can also hedge your S&P long positions by selling at-the-money or slightly out-of-the money calls with some downside protection and not limiting the up side too much. Backtest research has showed that this would provide less volatility to P&L of your S&P long position without limiting the up side. Honestly, I would not pay someone 0.5% fee and tie up the capital for so long to get a risk/return performance lower than the aforementioned strategy.
I have used this strategy for a couple of my long positions, such as McD over the years. I have been selling covered calls against the McD positions to reduce the cost of the shares over a number of years. The call premiums and the dividends I have received over the years have reduce the actual cost of owning the McD shares to effectively zero. The current yield of McD relative to the current share price is slightly over 3%. However, in my case, my yield should be infinite as whatever dividend divided by zero dollars which is the cost of the shares to me is infinity.
Great article. I didn’t know about this product before. Also, I love your blog!
A lot of people posted comments without really reading through your article, and it’s a real shame. A lot of people also seem confused about how options can be dynamically hedged or how banks’ trading desks can do it. Unsolicited advice: I’d write up a couple of blog posts and answer with a short link. Most people won’t bother to follow up, but those people that do are your core audience you’re trying to build up, right?
I personally didn’t notice on the first read that the cost of downside protection includes forfeiting the dividends, it just didn’t cross my mind. After some thinking, the bank is obviously constructing something akin to LEAPS call option, so dividends are just naturally left out. But the marketing materials conspicuously omit that, and it’s absolutely crucial for a layman like myself to understand. This is advertising at its worst.
IMHO it was worth placing it front and center: no free lunch, you pay ~2.25% annual dividend yield and the counterparty risk. For that, you get something less volatile with properties that let you sleep at night. You still lose a lot to inflation, obviously (another think that a layman like myself doesn’t always keep in mind).
The counterparty risk is significant. Lehman Brothers had $18,600,000,000 of those notes outstanding when it collapsed, and it was a 100+ year pillar of the industry. When I look at Citi or JPMorgan corporate bonds, I see spreads well over 1% above riskless treasuries. And I think those bonds may well be overvalued. The 1-2% (and I personally think more like 3%) or so per annum counterparty risk is another portion of your payment – add the 2.25% dividend yield, and the cost of good night sleep is starting to really add up.
I haven’t found LEAPS pricing, but I suspect it’s within that range. The bank can be very efficient in constructing the derivative, so maybe buying the LEAPS call or buying the index and LEAPS put is more expensive. But it would be at least partially SPIC insured, liquid, and generally much more flexible.
I think it’d be worth running some stochastic simulations and showing the probabilities of capital loss and mean expected return in different scenarios, to demonstrate relative costs and tradeoffs between going “naked long” as you put it, buying one of the two notes, or constructing this with LEAPS (or traditional) options.
Lastly, I don’t buy some people’s critique that this is european style option product. So what? European style means much cheaper to buy, and if you exit in the depth of a recession, guess what? You still keep your dollar capital that will now buy you much more stock. So you buy stock – and you’re an all-round winner in that scenario.
Btw it’d be interesting to see how much you lost (or rather, not gained) when you sold the note, comparing to if you just went naked long S&P500 with dividend reinvesting.
And the very last – the critique of Dow30. It’s a horrible index devised before computers that shouldn’t be used to measure anything; but it performs remarkably similar to S&P (which itself isn’t good; it changes methodology and because so many people invest in it, it’s overweight in large caps, otherwise there would not be enough small caps stocks to go around) or Wilshire. That’s because you can just choose a bunch of stocks and weights simply throwing darts – and they will likely perform very similar to the market, given large enough sample. I don’t like Dow but I wouldn’t be overly concerned with its archaic methodology or lack of diversity.
Sounds great. Where are you investing now and what is your net worth composition? Do you work in finance?
Most of my networth is in my business (tech, not finance) , so … I’ve been actively avoiding diversification in that aspect for a while now. Besides that, I have ~400k in 401k and ~400k paid-off house. The 401k would be considered diversified in the sense that I have 20% in intermediate and short-term bonds and money market (mainly to deploy when/if the next market correction happens), 20% in foreign stocks, 20% large caps, 20% mid caps, and 20% of small caps and misc. date-target funds. I arrived at that distribution completely by chance over the years, mostly by haphazardly buying more of whatever I thought was less risky or more valuable at the time, rather than strategically rebalancing, but I think I’m fine with that asset allocation right now, even though the stock market has record-high PE.
However, that’s not real diversification. Yale endowment is real diversified: they have absolute returns, illiquid real estate, and generally assets that aren’t highly correlated to US stock or bond markets.
I’m nearing a series of liquidity events and have to think what to do next, besides I’ve always been interested in business and finance. Eyeing the private equity market now (not as core investment, but as an addition to portfolio in order to diversify and acquire a new skill that may be very useful when managing my – hopefully – future wealth). Crowdfunded Real estate private equity looks particularly interesting to me.
Other than that, I’m thinking about building a value-oriented taxable portfolio after my exit. Fortunately it’s staggered so I’ll have a chance to try with a smaller portfolio at first. I’m reluctant to enter at this PE and I’m very reluctant to manage my soon-to-be-built portfolio myself (having no experience), but I’m even more reluctant to trust a FA because none of them strikes me as particularly bright or having interests that are really well aligned with mine. So I’m considering just giving most of it to a roboadvisor and maybe buying OTM LEAPS put as a bit of downside protection while I learn to manage my own portfolio.
Followup: I didn’t find LEAPS pricing, but here’s a paper about Lehman Brothers notes. In particular, on page 4 they say that the S&P500 100% participation principal protected note, presumably sold for over $100 (including front-loaded commission), was actually worth $89.27 when valued as a combination of zero-coupon note and a long term call option (which is what it was). I want to know this, and also how much it costs to construct the note myself and what’s the insolvency risk before I start thinking about the payout profile of the note and whether it makes sense to buy it.
And I forgot the link to the paper. they give valuations of several derivative notes. They don’t go in-depth with the assumptions of their valuations (implied volatility, interest rate or insolvency risk numbers are omitted) so I guess you’ve got to “trust them”. In any case, I’m assuming their valuations are theoretical, not taking the real-life inefficiencies of a retail investor into account. However, being under impression from reading the paper, I believe they’re right in the sense that you buy about $0.90-$0.94 for a dollar when you buy a structured note from an issuer. The payoff looks attractive on the surface and lets you sleep better, but that’s what those notes are constructed to do – it’s a psychological benefit, not financial. So I’m leaning towards my initial idea of buying the securities outright (and building my ideal value portfolio, not settling for the flawed S&P500 approach), employ some tax-loss harvesting (impossible with these notes), and maybe (just maybe) buy a 10% out-of-the-money long-term european-style put to sleep better at night.
Here’s the forgotten link:
Please poke holes in my thinking, that’s what I’m here for!
Swedroe (whom I’m not particularly fond of, but does respect mind-independent data) said it well:
> If the fiduciary standard of care were applied to the sale of financial products, it’s likely that
> virtually all structured notes would disappear. If a person selling the product cannot
> demonstrate that purchasing it is in the buyer’s best interest, why should that sale be
> allowed? I can’t think of a single reason.
Furthermore, speculating on a 70-page disclosure, complex structured linked product is just begging the wolves to have you as a rack of lamb for dinner. Because that is what you are doing when you say to yourself: “Oh, I don’t think the market is gonna go down more than 30% in 5 years.” based on zero independent and verifiable facts. And lastly, this jewel from Securities Litigation and Consulting Group:
> The spectacular failure of Lehman brothers in September 2008 left investors holding more
> than $18.6 billion face value of what had been previously sold as low risk investments but
> which were now worthless. The Lehman experience is especially instructive of the
> opportunity for mischief presented by financial engineering; faced with increasing borrowing
> costs Lehman stepped up its issuance of structured products where its credit risk would not
> be priced into the debt. The harm thereby inflicted on retail investors was a direct transfer
> from unsophisticated retail investors to Lehman and UBS which co-underwrote much of the
> Lehman Brothers structured product issuance. This transfer from retail investors was only
> possible because Lehman and UBS made the structured products increasingly complex and
> opaque.
This is great. What are you investing in right now and what is your net worth composition currently?
I’m always looking for skepticism because it helps me see the other side before making any investment. It also potentially provides much more upside. One of my best investments was Netflix in 2006. Everybody said it was going to just die. Oh how sweet the ride has been.
I’m also looking for some good investment ideas today. Thx
Hello Sam,
Your article got me interested enough to revisit this product with my banker. He is offering a similar product but less appealing (to me) due to a capped upside. The downside has a 15% buffer (e.g., if the S&P declines by 35%, my loss will be 20%).
Do you have any opinions on these terms compared to yours?
Did you talk about liquidity for your product? My banker says I can sell at any time at the published price but its unclear how that price correlates to the S&P 500.
Maximum Redemption Amount: 146% to 151% of the Principal Amount of the Securities ($1,460 to $1,510 per $1,000 Principal Amount of the Securities), to be determined on the pricing date
Buffer Level: 85% of the Initial Level
Buffer Percentage: 15%
Leverage Factor: 150%
Underwriting Discount and Commission: Up to 4.50% to Agents, of which dealers, including Wells Fargo Advisors, LLC (“WFA”), may receive a selling concession of up to 2.50% and WFA will receive a distribution expense fee of 0.12%
Read the prospectus carefully. My guess is it says something like “a secondary market may develop but is not guaranteed”. there is no requirement for them to make a market for you to sell into, let alone at the price where the note is marked on your statement.
What is the maturity of the note?
It’s a 5 year note and I’ve been told there is a daily NAV. I can sell within one day like a mutual fund but the NAV calculation is not straightforward since it will be based on option pricing and available buyers/sellers.
Sam, some thoughts based on the article & your replies to various comments here.
– I agree with most of your macro outlook, but am a bit concerned with where this note leaves you positioned. Of particular relevance to the terms of the note might be how one interprets current valuations & the autocorrelation of valuation metrics (how long valuations take to mean revert): https://www.hussmanfunds.com/wmc/wmc160926.htm
– I totally get that we can’t know when the party will stop on a high-flying market, and I don’t mean to imply that I or anyone else know where we’re headed. Your point – that structured notes help people from missing out on gains without having to do any complicated options positioning- is a really good one.
– Although the terms of the note you found might have attractive terms relative to notes you’ve looked at in the past due to current options pricing, you probably should recognize that there’s a reason this deal exists right now. The terms might be highly attractive –in general– but may be not so great a deal based on current expectations in the market.
– If you’re so worried about principal protection – why aren’t you willing to give away upside for larger downside protection, given your note’s time horizon?
– By locking up money in an over-valued market, you’re giving away substantial buying optionality in the event of a down-turn. Given your views, why not restrict yourself to cash and shorter duration securities with minimal solvency risk?
– You’ve mentioned that there’s less leverage out there than in the lead-up to the financial crisis…. credit has massively expanded. Where is it all sitting? On a related note… why expect a pull-back of less than 30%, when pullbacks of more than that have been historically common in equities?
– If you’re so worried about principal protection – why aren’t you willing to give away upside for larger downside protection, given your note’s time horizon?
Because I don’t think we’ll correct by more than 30%.
– By locking up money in an over-valued market, you’re giving away substantial buying optionality in the event of a down-turn. Given your views, why not restrict yourself to cash and shorter duration securities with minimal solvency risk?
I am for the money I do lock up. But I spend less than I make, and have a significant amount of excess cash each month and a large influx in 1Q2017 due to an expiring CD and bullet payment on an investment I made in 2009/2010 as part of my bonus.
– You’ve mentioned that there’s less leverage out there than in the lead-up to the financial crisis…. credit has massively expanded. Where is it all sitting?
It’s all sitting in cash. People are cashed up to the gils and haven’t fully participated in this recovery.
What is your background and where are you investing your money?