Personal Finance

How to invest without fear or FOMO


Only minutes after I was gloating that my retirement pot had reached half a million pounds a fortnight ago, mum called to say dad was knocked off his motorcycle and in hospital.

My pride. His fall. I’ve never read the Old Testament, however I’m pretty sure that is not the way Proverbs 16:18 is supposed to work. A car ran a red light and ruptured his bowel.

Not what you need at 82 years old. By the time I landed in Sydney, my plane was out of scotch and dad was out of theatre. Shit happens, I said to the surgeon. Let’s hope so, he replied.

Only a month after my boat exploded and two years since a lame joke lost me my job, this latest drama underscores the vicissitudes of life. I’m sure readers have their own tales of rapidly changing fortunes.

Please email me and I’ll read them to my new patient — but no funny ones lest he pops his staples. The ups and downs of markets is a good topic. Humourless, yet fascinating.

Especially this week’s wobble in stocks. What gets me is still how few investors reckon such drops are worth worrying about compared with the past few years. While up a bit, the cost of three-month protection against a small drop in the S&P 500 versus that of potential gains, for example, remains about half the average since 2021. 

In other words, equity owners are not fretting over scratches to their handlebars, to abuse dad’s accident for metaphors. The extraordinary rise in stocks the world over during the first quarter has pushed bullish sentiment indicators to extremes.

At the same time, though, fears of a wipeout gnaw. Consider the Chicago Board Options Exchange’s volatility index, which measures expectations of future volatility in US stocks. The cost of call options (the right to buy the index in future at today’s price) was recently the most expensive for five years relative to put options (the right to sell).

So markets are betting on more volatility ahead, not less. Either stocks rallying due to interest rate cuts, perhaps, or an artificial intelligence-induced productivity spike. Or crashing, say if inflation returns (America?) or geopolitics worsens.

Any of these scenarios is possible. As usual, no one wants to miss out while everyone else is riding off with the wind in their hair. But it is also natural to fear hitting the pavement and eating with a straw.

The problem is easy to solve — in theory. Just sell everything moments before a crash and buy again ahead of the recovery. Back in real life, professional investors use derivatives to protect their backsides while maintaining exposure to the open road.

But institutions have access to the world’s derivative exchanges as well as armies of smart bankers keen to sell them innovative structured products. All for relatively low fees, given their scale.

What about us retail punters, eh? Actually, there are exchange traded funds that have been designed with exactly the twin fears above in mind. These are popularly known as “buffered” or “defined-outcome” ETFs.

Buffered funds hold a basket of customised options in a manner that limits your losses (say to 15 per cent) over a given period (say a year). The catch is that any gains are capped (say to 10 per cent).

You can pick your downside protection. The upside, meanwhile, is a function of market conditions. Interest rates are important. And because these funds earn a premium selling options which they use to buy protection, when volatility is low, so generally is the upside cap and vice versa.

Option prices are sensitive little dears. Upside caps therefore can differ widely as new funds are launched. At the start of 2022, the popular Innovator US Equity Power Buffer ETF had a 9 per cent cap. A year later it was more than twice that.

Of course, two years ago US equity investors would have been grateful for the protection of a maximum 15 per cent loss — the S&P 500 finished a fifth lower. Buyers of the January 2023 fund would have enjoyed their 20 per cent, but the market rose 5 per cent more.

Likewise, buffered funds underperformed last quarter. And, due to the low volatility in equities now, the upside caps on offer these days aren’t great. Also note you only bag the advertised protection and cap if you invest at inception.

Such whizz-bangery isn’t cheap — the median fee across the 230 funds available in the US for example is 80 basis points, according to Morningstar data. Another catch is that returns exclude dividends.

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

I think I’ll pass, however — and here is my logic. Most developed equity markets simply aren’t accident prone enough to warrant protection, and they rally too often to suffer a cap. Even the rubbish FTSE 100 rises more than 14 per cent one year in three on average, if the past 30 are a guide. And it has only fallen more than a tenth seven times and more than 5 per cent nine times.  

Plus I have a quarter of my portfolio in bonds in case shares take a tumble. And the stocks I own are cheap, which should mitigate any correction. If inflation causes a sell-off, my energy ETF is also there to help.

But I appreciate there are many investors who crave protection. They may well need it. For them, buffered ETFs are worth a look. I see my dad on the other side of the ward nodding his sore head.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; Twitter: @stuartkirk__



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