Protection: Floors and Buffers
When I meet with prospective clients and even current clients, a lot of times they will tell me there are three things they want from their investments; make as much as they can, not lose their principal, and have full liquidity. My response is always the same, I can do all three of those but not in one single investment. In order to have the protection of principal, unless you put your money in the bank where currently one earns very minimal interest or as like to call it .0 nothing, you must be willing to give up full liquidity. For people that are willing to do that with a portion of their monies that they feel strongly about protecting, there are two strategies that can be used to get solid protection and upside potential.
A floor strategy is used by insurance companies in certain annuities that give the client a floor or stop loss on the amount of money they can lose in a contract year or defined time period the insurance company proposes. The upside performance can be based on an index or multiple indexes such as the S&P 500 or the Russell 2000. In most cases, because your downside risk is limited, your upside potential is also limited or capped.
For a hypothetical example, let’s assume you choose to invest in a floor strategy and the options are based on the S&P 500, your downside risk is 10% and your upside potential is 12%. That means in a contract year if the S&P does poorly and goes down 25% your investment would only go down 10%. However, if the S&P does very well in a contract year and goes up 25% your investment would only go up 12% because that was the cap in this hypothetical scenario.
A Buffer strategy is almost the opposite of a floor strategy in that it gives the client protection on the initial loss up to a certain percentage in a contract year. Like the floor strategy, the upside performance can be based on indexes with an upside cap. A downside buffer can lessen the pain of market losses because the insurance company takes on some of the initial risk.
For a hypothetical example, you are considering a buffer strategy for a portion of your money and the options are based on the S&P 500 your buffer is 10% and your upside potential is 12%. In a contract year, if the S&P goes down 25%, the insurance company will absorb the first 10% of the loss meaning your investment only goes down 15%. Again, just like the floor strategy example, if the S&P goes up 25% in a contract year your upside would be 12%.
Remember, both concepts go back to one’s desire to protect a portion of their money and forgo all the growth. If the index really went down 25% in a year, wouldn’t you be happy that you only lost 10% because of your floor or if you only lost 15% because of your buffer? I think it is good to look at floors and buffers as good compliments to each other. You will protect yourself better with a buffer in years the investment options do not go down more than your buffer. However, you will protect yourself better with a floor in years the investment options go down considerably more than your floor.
One often overlooked potential value add within these strategies is with most investments that do not have a downside protection feature, if you lose 25%, you must make up that 25% before you start actually earning again. With these strategies, although you did not fall 25%, you start the next contract year at that low point so if the index bounces back, you start earning more quickly.
The protection these investments can offer could be very appealing to certain individuals. In the markets today it may feel like we are reaching a high point given the changes in the political and social climate especially but there is no way to know for sure. If you are looking to protect some of your money, beyond an emergency fund that you will not need access to in the immediate future but want to earn more than the bank is currently giving, one or both strategies may be a fit for you. Or you may want to partially protect some of the gains in your investments during this positive market run over the last 10 years or so, floors and buffers may be worth considering.
Craig McDaniel Jr.
Certain information herein has been obtained from third-party sources believed to be reliable, but we do not guarantee or warrant its completeness or accuracy. This commentary is a general communication and is provided for informational and/or educational purposes only. None of the content should be viewed as a suggestion that you take or refrain from taking any action nor as a recommendation for any specific investment product, strategy, or other such purpose. In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional.