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 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 we do correct. Not once have I regretted paying down debt, even if the money could have made more money in an investment.
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 an investment idea 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 because 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 would get 100% of my money back provided the issuing bank was 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 2016 to spend on 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 June 1, 2017 when the note expires.
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 latest 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. Study the chart and see if you can understand what this note is offering on your own. We’ll then discuss the terms in detail.
Investment Idea At The Top Of The Market
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.
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.
In the bear scenario, 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.
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 after Hillary wins where the market actually goes down. There could be another international debt crisis that brings the world to its knees. Who knows for sure.
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 don’t need 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 have a long-term outlook and 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 invest. Low cost digital wealth managers like Betterment help reduce such fears by building, investing, and rebalancing a risk-adjusted portfolio for you in public securities.
But if you have more than $100,000 – $250,000 to invest, many big banks such as JP Morgan Chase and Citibank offer their private clients alternative investments that help protect principal while also providing 100% or greater participation on the upside.
As someone who is neutral on the stock market after an 8+ year 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.
Explore real estate crowdsourcing opportunities: 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 so you can track your net worth, analyze your investment portfolios for excessive fees, and run your financials through their fantastic Retirement Planning Calculator. Those 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 2020 and beyond.