Sequence of returns is the biggest risk to your portfolio when you are close to retirement, or in the early years of retirement. If your portfolio loses a lot of money in that critical period, you will not have enough time to recoup your losses to maintain your desired lifestyle in retirement.
Risk from bad initial sequence of returns
Sequence of returns means how your portfolio performs sequentially over time. For example, in the 1st year if your portfolio returns 5%, in the 2nd year it returns 8%, and in the 3rd year it returns -18%, then your sequence of returns is 5, 8 and -18%.
Imagine your portfolio loses 50% when you are about to retire, or in the first few years of retirement. It will need to gain 100% just to return to its original value before the loss!
Portfolio Hedges
Just like you buy insurance for your house so if it burns down, your insurance company covers your loss, you can buy insurance for your investment portfolio. The portfolio insurance can cover some or all your investment losses. This portfolio insurance is also called portfolio hedge.
There are two types of commonly used portfolio hedges – Retirement Annuities issued by insurance companies, and Stock Options you can buy from the stock market.
Retirement Annuities
Annuities are insurance contracts that promise to pay you regular income either immediately or in the future. You can buy an annuity with a lump sum or a series of payments.
The insurance company invests your money and pays you fixed returns over the contract period, irrespective of the stock market’s performance. By buying an annuity you transfer your investment risk to the insurance company.
There are many types of annuities and a full discussion is beyond the scope of this blog. Investopedia has a detailed description on their site at https://www.investopedia.com/articles/retirement/121416/retirement-annuities-know-pros-and-cons.asp
Stock Options
Stock Options are financial contracts that derive their value from an underlying stock. There are two types of stock options – Call and Put Options.
- Call options allow the holder to buy the stock at a stated price within a specific timeframe
- Put options allow the holder to sell the stock at a stated price within a specific timeframe
Call Options
If you bought one Call option to Buy Apple stock for $350 within the next 60 days, you have the right to buy 100 units of Apple stock for $350 each, any time from now till the end of the contract, no matter what the stock actually trades for. The $350 is referred to as the Option Strike Price. The fee you pay for the contract is called Option Premium
If the stock price increases to $400 any time before the contract expires, you can still buy each stock unit for $350. On the other hand, if by the end of the contract period the stock price stays below the $350 strike price, the contract expires unused and you lose the fee paid.
Put Options
If you bought one Put option to Sell Apple stock for $300 within the next 60 days, you have the right to sell 100 units of Apple stock for $300 each, any time from now till the end of the contract, no matter what the stock actually trades for. The $300 is referred to as the Option Strike Price. The fee you pay for the contract is called Option Premium
If the stock price falls to $250 any time before the contract expires, you can still sell each stock unit for $300. On the other hand, if by the end of the contract period the stock price stays above the $300 strike price, the contract expires unused and you lose the fee paid.
Using Put Options for Hedging
You can buy Put options on the US stock market by buying options on a stock ETF called SPY. This ETF is a proxy for the entire US stock market as it includes the 500 largest capitalized stocks in the market.
By buying the Put option you limit your portfolio’s losses as the Put option pays for any loss below the option strike price.
If you have a $300,000 investment portfolio in US stocks, you can buy 10 Put Options of the SPY ETF with a strike price of $300. Since each Put Option controls 100 SPY ETF units, the 10 Put options will control 1000 SPY ETF units worth $300,000. If the SPY ETF price drops below $300 you can exercise the Put option for $300, thus putting a floor on your investment value which cannot fall below $300,000. Of course, if the stock market goes up and the SPY ETF stays above $300, you lose the option premium at the end of the option contract.
How to buy Options
You can buy options by opening a trading account with any of the major stockbrokers like E*TRADE, Ameritrade, Fidelity, and Tastyworks.
Note that option prices are influenced by the volatility in the stock market. When the markets start to fall the market volatility increases causing a spike in option prices. It is best to buy options when the market is calm to get lowest premiums.