This is the central illusion in life: that randomness is a risk, that it is a bad thing.
Since financial planning time immemorial, we have stated that retirees could withdraw approximately 4% of their portfolio at retirement, inflation adjusted, and not run out of money for a 30 year retirement.
A follow up study, called the Trinity study suggested a portfolio of 75% stocks and 25% corporate bonds.
The idea behind having bonds in the portfolio is that they tend to be inversely correlated with stock performance. Generally, when stocks go down, bonds go up, or, at least, they don’t go down as far as stocks do. They are meant to provide ballast for the bad years.
This is playing defense. It makes sense. The last thing that you want to do is run out of money before you run out of heartbeats. No retiree looks forward to going back to work as a Walmart greeter at age 85. While Social Security will ensure that you do not run out of money in retirement for the vast majority, running out of your retirement nest egg is an undoubtedly bad outcome, and it’s one that the safe withdrawal rate aims to avoid.
But is there a better way to play defense?
We examined one way with annuities, first when we interviewed Dr. Wade Pfau, CFA, and then, when we saw that retirees who had a guaranteed income were happier than those who had an equivalent net worth invested in the market.
However, another way exists, which is to use derivatives to purchase downside protection.
Specifically, I will examine whether or not buying puts provides equivalent downside protection.
What is a Put?
A put is the right but not the obligation to sell a stock at a given price at a given time.
Let’s take the example of XYZ stock.
Let’s say that we buy a put at $50 with an expiration at the end of the year.
If the stock is worth $100, then our put is worthless, as we would not want to buy XYZ at $100 to exercise our right to sell it at $50.
However, if the stock is worth $20, then our put is worth $30. We would buy the stock at $20 and sell it at $50, meaning that we would make $30.
In practice, these are cashless exchanges, and your brokerage will just put $30 in your account.
We can see the returns of a put on XYZ stock graphically.
How Are Puts Priced?
Put pricing (as well as call pricing) have two components to them:
- Intrinsic value. This is simply whether or not the option, if you exercised it right now, would be worth anything. If you bought the $50 put for XYZ and XYZ was currently priced at $20, then there would be $30 of intrinsic value. If you were ever to see the price of the option below $30 (you never would), you would buy it immediately for the arbitrage value.
- Time value. This is a function of how much time remains between the time that you buy the option and when the option expires. If you buy an option with a year before expiration, the time value will be more than if you buy it with 2 days left before expiration. A component of the time value is how volatile the stock is – how much it goes up and down over time. An option on very steady stock will have lower time value, all things being equal, than another whose underlying stock has wild gyrations.
By buying puts for your portfolio, you’re buying portfolio insurance – you’re paying a price to ensure that you don’t lose money during that time frame.
Of course, just like homeowner’s insurance protecting you against a fire, that insurance comes at a cost.
Before we look at my analysis that I conducted, let’s look at why you might choose this path versus the other two paths: 75/25 asset allocation and buying an annuity.
Why You Would Buy Portfolio Insurance Rather than have a 75/25 Asset Allocation
This one is pretty simple, and given the current wild market swings of the COVID-19 pandemic and the saliency of the market drop that people who retired just before the pandemic are feeling.
It’s that you can’t stand the swings.
You watch CNBC like a hawk (not a good idea), and every time there’s a negative number, you’re gobbling Pepcid in a fit of fear.
You’ll be tempted to panic about your retirement, which will cause you to over trade, and you’ll sell low and buy high.
This would lead someone with this type of disposition to want to buy an annuity and forget about the whole thing.
Why Would You Buy Portfolio Insurance Rather than Buy Annuities in Retirement
Currently, let’s say that you’re a 65 year old male who lives in Texas with a 63 year old wife.
You want $3,333/month, which is about $40,000 per year.
According to the safe withdrawal rate, you’d need $1,000,000 to put that money in the market and retire.
If you bought an annuity today, that annuity would cost you $815,343, but it would not have inflation protection, which you want. I can’t find an appropriate calculator for inflation adjusted annuities, so it’s safe to assume it would cost more, and potentially up to your $1 million. You’d either need to invest your $184,657 in the market to cover for inflation adjustments, or you’d have to pay much more to have the inflation rider.
Instead, you may want to invest everything in the market to take advantage of the generally higher returns and purchase the portfolio insurance via puts. You’ll still sleep reasonably soundly, and you may have more left when you run out of heartbeats for estate planning needs.
So, what are the results?
First, I assumed that the average retiree had $1,000,000 at retirement. The retiree withdrew SAFEMAX the first year and then added 3% each year to the spending to account for inflation. The retiree withdrew that amount at the beginning of the year. The retiree also paid a certain percentage of his portfolio to buy a put with a strike price at the current price of the S&P 500 and was otherwise invested 100% in the S&P 500. At the end of the year, if the put was in the money, then the effective returns for that year were 0%, since the retiree exercised the put and offset the losses in his portfolio. I also assumed, due to lack of data, that the price of the put was the same every year. After all, options have only been trading since April, 1973.
Then I looked to solve the maximum amount that this hypothetical retiree would be willing to pay in order to have zero 30 year retirement periods where he ran out of money – the same standard as SAFEMAX.
This amount was 7.86%.
In other words, as long as an investor could buy a put at the beginning of the year at the money for a one year time period, and that put cost 7.86% or less than the value of his portfolio at the time, he would not run out of money in any 30 year time period from 1928 through 1989.
Then, I looked to solve the price that an investor would pay in order to have every 30 year time period provide a superior end-of-period remaining balance to the 75/25 asset allocation cited in the Trinity study.
This amount was 2.29%.
So, if an investor could buy the same puts for 2.29% of his portfolio or less, historically speaking, he would be better off buying portfolio insurance and being 100% in the S%P 500 than being 75% in the S&P 500 and 25% in corporate bonds.
Finally, I wanted a sanity check to see if this was possible.
I looked at the price of SPY at the opening bell on the first trading day of 2020, which was January 2, 2020, and the price was $323.54. I then looked at the price of a SPY 323 put for December 31, 2020. It was $19.51 at the opening bell on January 2, 2020. That was 6.03% of the price of SPY at the opening bell, which satisfied the condition of being below 7.68%. At that price, historically, investing in a 75/25 asset allocation is superior 93% of the time.
Practical Challenges of Buying Portfolio Insurance as an Individual Investor
Let’s say that you wanted to eliminate the rollercoaster but wanted to try to leave some inheritance behind, so you wanted to choose purchasing portfolio insurance rather than an annuity. There are some challenges to doing so.
- Options trade in contracts that represent 100 shares. So, in the case of SPY for January 2, 2020, each option represented $32,354 worth of stock. That’s a weird multiple to try to solve for.
- Not every brokerage allows options trading. My USAA (soon to be Schwab) brokerage account allows me to trade options, because, once upon a time, I sent them a form and claimed that my MBA gave me some sort of rare knowledge (it didn’t). You’ll have to fill out a form to show that you understand the risks of trading options, and, even then, your brokerage may not allow you.
- Your math skills decline with age. Research shows that cognitive decline can start as early as 50, and the first skill to go is usually math. Do you want to be trying to figure out what put to buy and for how much when you’re 85? Probably no more than you want to be a Walmart greeter.
- You won’t have pricing power. Stocks and options are stated in two prices: the bid – how much a buyer will pay for a price, and the ask – how much a seller is willing to sell for. Since you’re going to be trading in small numbers, you’re going to wind up paying the ask. Hedge funds, with their buying power, will usually get a price a lot closer to the bid.
If someone in the financial planning or fund management profession wants to take up the gauntlet and run with it, there are a few more areas to explore that I’m not going to pay for a Bloomberg terminal in order to find out the answers to.
- Backtesting the strategy against real options prices. I did a hypothetical analysis and one sanity check with a 2020 price. I have no idea if this is even feasible given historical options prices.
- Incorporating calls to offset insurance prices in upside scenarios. Just as a put protects the downside, a naked call could amplify the upside.
- LEAPS. I looked solely at one year put options. Maybe there’s better pricing, and, therefore protection for 2 year LEAPS.
- Other hedging derivatives. I’m sure some quant genius has figured out the perfect hedges to buy. However, I’d be concerned about tail risk and concavity of returns in a tail scenario.
Have you ever tried to hedge your returns? Are there other areas of exploration I’m missing? Let’s talk about it in the comments below!