Stock Market Back to All-Time Highs: How to Stay Invested, but Limit Your Downside
What a wild ride. The S&P 500 has eclipsed 3500 from its March low of 2191 (a whopping 60% off of the lows).
Many investors are continuing to question this rally's steam, thinking that it makes no sense as the world is still facing COVID-19 concerns. I've gotten questions from clients asking what they can do to hedge a downturn, whether they should take some risk off of the table, and if they should "lock-in" some profits.
Some people simply do not like volatility (aka big moves up or down) and they don't have the stomach to go through another big swing.
Although the classic methods like rebalancing (sells some stocks that are up and buy some bonds/cash) the portfolio to be less volatile or trimming positions that have returned a large percentage do work, what are some other methods?
Enter Defined Outcome ETF's -
To keep things simple, these types of investments are ones that "buffer" your downside and "cap" your upside.
Example: Let's say an investor holds the S&P 500 index (SPY, VOO, etc.), but they aren't very confident that the index will continue to produce high returns over the next year or more. However, they don't want to totally move to cash and earn close to 0%. They want the best of both worlds.
What they could do is buy an ETF based on the S&P 500 that has a "defined outcome."
Innovator ETF's, for example, do the following:
For their August offering, they have a downside buffer of 15% (which runs from August 1st, 2020 to July 31st, 2021). Meaning that the first 15% downside in the S&P 500 is offset. Example: the index goes down 15% during that year period, you are down 0% (gross of fees). If the index is down 20%, you would be down 5%.
However, to keep fees low to buffer the downside, the fund caps the upside. In the same August offering, the cap 10.87% for the year. Mind you, a 10% return in any given year is still pretty good. Something to consider would be how you would feel if the S&P 500 returned 20% over that year. Your return would be capped at "only" 10.87%, so you'd miss out on 9.13%.
Overall, you'd have to think about what would hurt more:
Potential losses vs. missing out on potential gains?
That answer is different for everyone.