- “Loss Aversion” is when investors fear losses more than they enjoy gains
- There is a cost associated with trading off some upside potential to save on downside risk
- Structured investments (e.g. structured notes, covered calls, buffered ETFs) offer downside protection but give up significant upside potential in return
- Overweighting "safe" sectors may not provide the expected level of protection on the downside while also foregoing much of the market's upside since these sectors greatly underperform in normal markets
- Non-market investments (e.g. real estate, certificates of deposit, annuities) are sometimes sought out due to loss aversion but may not be right for everyone and require significant work if done correctly
- The best way to capture downside protection is through diversification and having a liquid emergency fund that fits the investor's timeline/horizon
For most people who invested their hard-earned money into the market, their biggest fear is suffering through some kind of market crash. Interestingly, research shows that most people fear losses more than they enjoy gains.
Unfortunately, loss aversion is something that Wall Street’s marketing machine is happy to prey upon, churning out any number of products that offer downside protection.
Not surprisingly, these products don’t really work. They might offer some modicum of downside protection but ultimately cost you far more than the benefit.
We believe there is a right and wrong way to protect your portfolio from down markets. Here is the reality about what works and what doesn’t.
There’s no such thing as a free lunch
Almost all strategies to reduce a portfolio’s downside risk also lower your upside potential. That’s a problem for long-term investors because the stock market has historically gone up much more often than it has gone down. Therefore, giving up a little upside to save a little downside will tend to cost you in the long run.
The chart below illustrates this point. It compares the Morningstar Global index returns over the last 20 years, assuming you capture different percentages of both the upside and the downside.
As an example, the red bar assumes a portfolio where each month received 70% of the index’s gain or loss. If the benchmark was down 5% in a month, the 70% portfolio was only down 3.5%, but if it were up 5% in a month, the gain was only 3.5%.
Here we see that on net, the 70% portfolio only gained 209% vs. 365% for the full index. To put that in context, $100,000 invested at the beginning of this period would have been worth $156,000 more being fully invested vs. trying to protect your downside with the 70% portfolio.
In our hypothetical above, we show that if you have an even trade-off between losses and gains, you will wind up behind in the long run.
Unfortunately, because everyone suffers from loss aversion, people tend to be willing to overpay for downside protection. In other words, generally speaking, if you want to reduce your downside risk by 30%, you need to give up more than 30% of your upside potential.
We can see this by looking at so-called “structured” investment vehicles. These take a few forms, including structured notes, covered call strategies, and, most recently, a new ETF product called a “buffered ETF.” These are all variations on the same idea: using derivatives to protect on the downside, but in doing so, also give up some upside.
Take the buffer ETF as an example. The oldest of these products is from a firm called Innovator ETFs. Each of these ETFs has some defined downside buffer.
For Innovator’s original buffer ETF (called the Innovator S&P 500 Buffer ETF - July), the buffer is -9%. If the S&P 500 falls 9% or less, your return is 0%.
If it falls more than 9%, your portfolio will lose the difference between the actual return and -9%. For example, if the S&P were down 12% in a 12-month period ending July, your portfolio would only be down 3%.
Of course, there is an upside buffer too. Currently, that is +14% for this fund. So, you get the full return if the market rises by 14% or less. However, your return is capped at 14%.
But if the market is up 30%, you are only up 14%. Note that this upside buffer changes every year. The derivatives used by the ETF are kind of like insurance contracts, and the price of insurance against a market downturn changes over time.
You might be thinking that this sounds pretty good. It sounds like you avoid most of the downside, and you can still make up to 14%, which sounds like a pretty good return. Unfortunately, the reality is much different.
This fund has only existed since 2018, but we can take this buffer of -9% to +14% and illustrate what might have happened over longer periods. We looked at the S&P 500’s returns over the last 40 years and measured each 12-month period ending in July to match the structure of the ETF. Here is how the returns of the S&P over that time have broken down relative to this fund’s buffer levels.
Source: S&P Dow Jones Indices
Already, the problem with this fund should become apparent. The S&P has only been down 7 out of 40 years, and in only 2 of those years was the loss within the -9% buffer. The other 5 times, your portfolio would have declined.
Meanwhile, in 17 of those years, or just under half of the time, the S&P was up more than 14%. In those years, this fund would have surrendered at least some upside.
If we translate that into cumulative returns, the result is devastating for the buffer ETF. To simulate a long-term return for this fund, we assumed the buffers of -9% to +14% stayed the same over time, measured returns at the end of July each year, and then applied the fund’s 0.79% expense ratio. The chart below shows that $100,000 invested in the S&P 500 in 1983 would be worth almost $7.2 million as of July 31, 2023. Our simulated buffer fund would only be worth $2.1 million.
Source: S&P Dow Jones indices, Facet calculations
Earlier, we talked about a hypothetical trade-off of 70% of the downside but only 70% of the upside. This buffer fund has a much worse trade-off. Over this 40-year period, it would have only captured about 57% of downside periods, but in exchange, it only captured 17% of the upside.
Therefore, it isn’t surprising that since its inception in 2018, this fund has returned only 35.2% cumulatively vs. 61.9% for the S&P 500. Despite the fact that there have been two bear markets over that short period, this fund has woefully underperformed.
Another common approach for downside protection is to overweight certain sectors that have historically held up well in down markets. Some classic examples are utilities, preferred, and high-dividend stocks.
All of these suffer from similar problems: they fail to capture much upside while not protecting enough on the downside. To illustrate this, we showed how each of these market segments performed during the last four major stock market downturns: 2008, 2018, the onset of COVID in early 2020, and 2022.
Source: S&P Dow Jones Indices
Here, we see that the so-called “safe” sectors are actually a mixed bag. They all lost money on net over the last four bear periods, with high-dividend stocks actually performing even worse than the S&P as a whole.
Meanwhile, all of these sectors far underperformed during normal markets. Turns out these sectors aren’t any kind of hedge.
If the market is down, they might save you some money, and they might not. But in normal markets, they are sure to cost you. Once again, the price of a little supposed safety is quite high and, in our opinion, not worth the cost.
Sometimes, loss aversion tempts people to move their money into assets that don’t “mark-to-market.” In other words, things where any change in value doesn’t show up on a bank statement, and therefore, you don’t have to think about money you may have lost.
Some of these can be good investments in the right circumstances, such as buying a rental property. However, this is closer to owning a small business than investing in markets. Between dealing with renters, paying for upkeep, etc., owning an investment property is a lot of work, and part of the return you get on such an investment reflects just how much work it is.
Facet sometimes recommends other non-market investments, including certificates of deposit or annuities. Both of these can help relieve the feeling of loss aversion since they usually offer some kind of guaranteed rate of return. However, in both cases, there are generally better options for short-term investing or retirement planning.
Other ideas are bad for almost everyone but can be psychologically appealing due to loss aversion. The recent fad of infinite banking is one good example of this.
If you are thinking about making any of these investments, it is a good idea to talk this through with your CFP® Professional. Ask yourself if this investment is really right for you, or are you just trying to avoid the pain of seeing paper losses in your portfolio?
What is the right way to get downside protection?
This isn’t to say you should ignore downside protection within your portfolio. However, there’s a right way to do it. One that allows you to grow your assets toward your goals. After all, while we know it is stressful to see your portfolio value decline, it will ultimately be more stressful not to realize your financial goals because your assets did not grow as they should have.
The easiest thing you can do to improve downside protection is to diversify your assets. Spreading out your risks is the one proven way to improve both risk and reward within a portfolio. This is especially true if you own individual stocks. The whole market isn’t going to zero, but one particular stock might.
The second easiest thing to do is to have an emergency fund. This account is invested in extremely safe assets and can be easily accessed (liquid) if something unexpected occurs. Such a fund allows you to avoid tapping your long-term investments just because a short-term emergency crops up.
Next, make sure your portfolio’s allocation fits your investment horizon. Someone investing for retirement with a timeline of 20 years doesn’t really need protection from occasional market dips. In contrast, someone currently in retirement needs to be much more sensitive. Facet has specific recommendations for investors in both situations, matching the right balance of protection and asset growth.
By specifically defining the various purposes for your money, you can more easily separate how you might feel about a market drop from its actual financial consequences. This is how one builds resiliency into your assets.
We can’t control what the market does in the short term, and as we’ve shown above, using gimmicks to provide a veneer of downside protection is ultimately significantly expensive. Focusing on a solid plan that builds in this resiliency is the best way to ensure that market volatility doesn’t keep you from achieving your financial objectives.