Let's first discuss how ridiculously easy it was to actually match or even beat the S&P 500 when it advanced...yet lose nothing if it went down or even crashed...back when interest rates were higher.
This was done, by the way, without using stocks at all!
A "call option" which allows the investor to capture 100% of any appreciation on $100,000 worth of the S&P 500 over a 1-year period might cost roughly 6% or $6,000. So if the S&P was up, say, 15% at the end of the period, the call option would expire with a value of $15,000.
Let's also assume...as was often the case years ago...that good quality bonds, CDs, Treasurys and the like maturing in 1 year paid in excess of 6%
Instead of taking the client's $100,000 (or any multiple thereof) and putting it into some stock picking strategy or fund...which was almost sure to underperform the S&P at best and lose money at worst...we would invest $94,000 in the fixed income instrument and $6,000 in the call option.
Since the interest earned would offset the cost of the call option, the $100,000 investment would be worth $115,000 at the end of the 1-year period, matching the S&P. On the other hand, if the market had declined or crashed, the investor would still retain his original $100,000.*
Heads he wins...tails he doesn't lose!
(It should be pointed out that although this technique was available to any of the thousands of Wall Street "pros" during those years, the more traditional stock picking strategies and funds continued to proliferate, underperforming at best and losing big in the inevitable bear markets!)
But that was then. What about now, when interest rates are much lower and unable to cover the cost of those call options?
Once again, let's assume an investment of $100,000.
With $94,000 of that we are going to buy an FDIC-insured 1-year CD or other super safe fixed-income instrument paying the now low 2.3%. Thus, we will now only have $2,162 coming in over the next year.
Next, we will buy the 1-year call option on the S&P 500 Index for around $6,000.
As in the example above, if the S&P is up 15% at the end of the 12 months, the call option would still be worth $15,000 at expiration. However, since we paid $6,000 for the option, but only received $2,162 from our fixed-income instrument, our net cost would be $3,838, reducing the total return on our $100,000 investment to $11,162 or 11.16%*
So, IF we just purchased the CD and S&P index option and did nothing else during the year, our total return would be whatever the S&P option achieved minus $3,838. Moreover, if the S&P declined, we could actually lose $3,838 or 3.8% (but that's all) on our original investment.
That's IF we did nothing else during the year!
In fact, we are going to be doing several things during the year to reduce or eliminate that $3,838 shortfall. Losing only 3.8% might look good if the market declined more than that, but we want to lose little or nothing in even the worst market scenario.
Throughout the year, we will periodically be selling short term S&P index options for cash, seeking to wipe out most or all of the $3,838 shortfall. No additional funds have to be invested, as we are selling, not buying. And these short term options are backed by the initial 1-year option.
Investing in this manner, we will end up realizing most or all of any appreciation in the S&P 500 during the year as our total return.
If the S&P declines or even crashes during the year, we will still recover most or all of our original $100,000!
(Yes, this is a little more complicated than an index fund or buying and selling stocks. But how else can you capture 100% of the upside in the market with little or no downside risk?)
In the last 20 years, the S&P 500 experienced rolling 12-MONTH PERIODS during which it:
Lost 10% - 20%....................18 times
Lost 21% - 30%....................14 times
Lost 31% - 40%......................6 times
Lost 40%+..............................2 times
In short, there were 40 different 12-month periods in the last 20 years when you could have lost anywhere from 10% to more than 40%!
Anyone who bought near the top in 2007 needed 6 YEARS to get back to even!
Anyone who bought near the top in 2000 needed 7 YEARS to get back to even!
Avoiding losses, bear markets and "Black Swans" is the key! That is something that almost no stock-picking strategy or index fund is capable of achieving!
Remember that at the very outset, the CD and call option purchases guarantee that we will capture 100% of any appreciation on $100,000 worth of the S&P 500, with an initial maximum possible loss of only $3,838 or 3.8% ...which we will then proceed to reduce or even eliminate during the year.
Regardless of how low the S&P might decline or even crash, our maximum loss would be less than 3.8%, and possibly as little as zero!
Consider an investor who buys $100,000 worth of the S&P in the conventional way, say in an ETF such as SPY. That investor will capture 100% of any S&P advance, but he would also suffer losses in any market decline, in some instances catastrophic losses!
By capturing most or all of any S&P gains in bull market years...and suffering little or no loss in the inevitable bear market years...the investor significantly outperforms the market...as well as the "pros"!
*Taxes are excluded. Commissions are negligible.