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How to Invest Without Fear or FOMO

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Just minutes after I was rejoicing that my pension pot had reached half a million pounds a fortnight ago, my mother called to tell me that my father had been knocked off his motorbike and that he was in the hospital.

My pride. His fall. I’ve never read the Old Testament, but I’m pretty sure that’s not how Proverbs 16:18 is supposed to work. A car ran a red light and ripped out his intestine.

This is not what you need at 82 years old. By the time I landed in Sydney, my plane was out of tape and my father was no longer in theater of operations. Shit happens, I told the surgeon. Let’s hope so, he replied.

Only a month after my boat exploded and two years after a lame joke caused me to lose my job, this latest tragedy highlights the vicissitudes of life. I’m sure readers have their own stories of rapidly changing fortunes.

Please email me and I’ll read them to my new patient – but no funny ones lest he pop his staples. Market ups and downs are a good topic. Humorless, but fascinating.

Especially the stock market oscillations this week. What still amazes me is how few investors believe such declines are worth worrying about compared to recent years. Although up slightly, the cost of three months’ protection against a slight decline in the S&P 500 relative to that of potential gains, for example, remains about half the average since 2021.

In other words, shareholders don’t worry about scratches on their handlebars, to use Dad’s accident as a metaphor. The extraordinary rise in stocks around the world during the first quarter pushed bullish sentiment indicators to the extreme.

But at the same time, fears of erasure gnaw away. Consider the Chicago Board Options Exchange Volatility Index, which measures expectations of future volatility in U.S. stocks. The cost of call options (the right to buy the index in the future at the current price) was recently the highest in five years compared to puts (the right to sell).

In other words, markets are betting on more volatility, not less. Either a rally in stocks due to interest rate cuts, perhaps, or an artificial intelligence-driven productivity spike. Or a collapse, for example if inflation returns (in America?) or if geopolitics worsens.

Any of these scenarios is possible. As usual, no one wants to miss anything while everyone leaves with their hair blowing in the wind. But it’s also natural to be afraid of hitting the curb and eating through a straw.

The problem is easy to solve – in theory. Just sell everything moments before a crash and buy again before the recovery. In real life, professional investors use derivatives to protect their backs while maintaining exposure to the road.

But institutions have access to global derivatives exchanges as well as armies of savvy bankers eager to sell them innovative structured products. All for relatively low costs, considering their scale.

And us retail punters, eh? In fact, there are exchange-traded funds that have been designed with exactly the two fears above in mind. These are commonly referred to as “buffered” or “outcome-defined” ETFs.

Buffer funds hold a basket of options customized to limit your losses (say to 15%) over a given period of time (say a year). The problem is that all winnings are capped (say at 10 percent).

You can choose your downside protection. The increase, in turn, depends on market conditions. Interest rates are important. And because these funds earn a premium by selling options that they use to buy protection, when volatility is low, the upside cap usually is too and vice versa.

Option prices are sensitive, my dear ones. Upside caps can therefore vary significantly as new funds are launched. At the start of 2022, the popular Innovator US Equity Power Buffer ETF had a cap of 9%. A year later, it was more than double.

Of course, two years ago, investors in US stocks would have been grateful for protection against a maximum loss of 15 percent – ​​the S&P 500 finished a fifth lower. Buyers in the January 2023 fund could have taken advantage of their 20 percent, but the market rose another 5 percent.

Likewise, buffered funds underperformed last quarter. And, because of the current low volatility in stocks, the upside caps on offer these days aren’t great. Also note that you only get the advertised protection and cap if you invest from the start.

Such splurge doesn’t come cheap: The median fees for the 230 funds available in the U.S., for example, are 80 basis points, according to Morningstar data. Another problem is that the returns exclude dividends.

Despite these drawbacks, assets have more than tripled in the past two years, even though most of the action is in the United States. My UK online broker offers me a few S&P 500 funds and a FTSE 100.

However, I think I will pass – and here is my logic. Most developed stock markets are simply not crash-prone enough to warrant protection, and they rebound too often to plateau. Even the poor FTSE 100 rises by more than 14 per cent every third year on average, based on the last 30 years. And it only fell by more than a tenth seven times and by more than 5 percent nine times.

Additionally, I have a quarter of my portfolio in bonds in case stocks fall. And the stocks I own are cheap, which should smooth out any correction. If inflation causes a sell-off, my energy ETF is also here to help.

But I understand that many investors crave protection. They might just need it. For them, buffered ETFs are worth a look. I see my father across the room nodding in pain.

The author is a former portfolio manager. E-mail: [email protected]; Twitter: @stuartkirk__

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