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Principal Protecting Your Investments

The following is a guest post from Dylan Ross, CFP and founder of Swan Financial Planning.

How would you like to like to participate in the good stock market returns, but not lose any money, even if the market goes to zero? No, I’m not about to invite you to a free lunch seminar to pitch an annuity. There is actually a very simple way that just about anyone can invest some money in the stock market while guaranteeing that your starting balance will be available at a future date.

The basic idea behind this strategy is to use enough U.S. Treasuries or money in FDIC insured CDs to guarantee a future value that is equal to principal. Then, invest the difference in the stock market. Even if you are not interested in principal protecting your investments, understanding this concept can help frame your understanding of the relationship between risk and return.

How It’s Done

While there are several ways to construct such a strategy, here is an example of how to protect $20,000 and still seek some growth over a five-year period. First, you’ll need to find a CD or Treasury note with the maturity you want and a competitive yield. Let’s use a 5-year CD with a 3.5% APY for this example.

Next, you need to figure out how much to invest in that CD so that your balance will equal $20,000 at maturity. In this case, $16,840 will get you there, leaving $3,160 to be invested in the stock market using a low-cost, no-load total stock market index fund.

Possible Results

If after five years, your stock market investment is flat, your $20,000 will have grown to $23,160, about a 3% annualized rate of return.

If the market losses half its value each year for five years in a row, you’ll still have $20,098, even though the market lost about 97% of its value over half-a-decade!

If the market does well and averages 10% for the next five years, you’ll have $25,078. That’s a little more than a 5% annualized rate of return.

In fact, when the market does better than the CD’s APY, you will have done better compared to putting all of your money in the CD, but no matter how bad the market does, you won’t lose your original principal.

Keeping It Going

You can follow the same process with future contributions, buying additional CDs and adding to your total stock market fund. When a CD matures, you can repeat the process, protect your principal after adjusting for inflation, or even lock-in your stock market gains. There is no right or wrong way to do this. If you understand the trade-offs and mechanics of this strategy, you can customize it to meet your own needs.

You may be comfortable with protecting only a portion, perhaps only enough to withstand a 20% market decline over five years (with the CD from the example, a 50/50 split gets you pretty close). Also, keep in mind that when CD and Treasury rates are higher, less money is needed to principal protect, leaving more to be invested in the stock market.

Other Considerations

Of course, the best place to execute such a strategy is in a tax-advantaged account, at least for the income-producing portion. Otherwise you will need to allow room for taxes by aiming for an after-tax future value. Also when using CDs to principal protect a portfolio, keep in mind that FDIC insurance covers deposits but not any yet-to-be-credited interest.

Now, I’m certainly not suggesting everyone go out and do this. But the example should help to illustrate the relationship between risk and return. Even as you begin to deviate from the example in pursuit of greater returns, the relationship between risk and return persists. Lastly, it’s okay to be conservative with your investments as long as you are willing to make up for it in other areas, like saving more, saving longer, or planning to live on less.

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Comments

  1. There is a great need for discussion of risk-reduction strategies. The risks of stock investing have been greatly understated during the Passive Investing Era and there is a great thirst today among middle-class investors to learn about more realistic long-term strategies than those that have been widely promoted in recent decades.

    I am not entirely comfortable with strategies that require that investors lower their stock allocations across the board. The problem is that stocks really are in a general sense the ticket to financial freedom for middle-class investors and lowering your stock allocation means passing up opportunities for growth of your portfolio. Millions are already behind on their plans to finance their retirements. Giving up more growth opportunities is not going to help.

    I believe that the future of stock investing advice is learning to distinguish the times when stock investing is an insanely risky thing to do in the long term (times of high prices) and times when stock investing risk is moderate or low for long-term investors (times of moderate or low prices). This approach provides investors the best of all worlds — the great returns generally associated with stock investing without the insane risk taken on by those who invest passively (those who do not adjust their stock allocation in response to big price changes).

    Rob

  2. I understand the desire to protect assets. I constantly preach doing just that.

    When interest rates are high, this program has appeal because there’s a reasonable sum left to invest in the market, and most investors like the idea of being invested (passive or active). But with interest rates low, does this program have followers? Are people just looking ‘not to lose’?

    I’m sure I don’t know the answer.

    NOTE to BOB,
    Yes, avoiding the market does eliminate the best chance an investor has for growth, but that growth is not guaranteed. The truth is that avoiding the market also eliminates the best chance for negative growth.

  3. Isn’t this just a verbose way of saying, ‘if you want to protect your principal, put 80% of your portfolio in government bonds?’

  4. avoiding the market does eliminate the best chance an investor has for growth, but that growth is not guaranteed.

    My thought is that all in the investing field should be focused on these questions today. Nobody has all the answers. But my hope is that we all can learn more by putting our heads together and coming up with creative solutions. I believe that the crash will come to be viewed as having been a positive if we take advantage of the opportunities to explore new ideas that it opens up to us.

    Rob

  5. Interesting case study, though I agree with Adam that it complicates a simple idea to ensure you hit an exact amount of money in five years time. Then again, investors might like the psychological security.

    I certainly prefer it to opaque structured products!

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