It is useful to ask the following two questions when talking about risk with people:
The first question is, "If your portfolio was up 50%, would it change your life?"
The second question is, "If your portfolio was down 50%, would that change your life?"
I have found, asking clients above 60, that the answer to the first question is usually no, and the answer to the second question is usually yes.
Following that discussion, it is helpful to ask a client how much he would have if he started with $1,000,000, lost 50%, but made 50% back the following year. So let's do the math.
$1,000,000 minus 50% = $500,000
$500,000 plus 50% = $750,000
So after that series of events, we end up with 75% of what we started.
The next question is how much would you have if you started with $1,000,000, lost 10% and then made 10% back the next year. That math is as follows:
$1,000,000 minus 10% = $900,000
$900,000 plus 10% = $990,000.
After that series of events, we end up with 99% of what we started with.
The lesson here is that people who would not benefit from a big upside shouldn't be taking excess risk. So having gone through this exercise, what should clients do?
First they should get their portfolio stress tested to see what type of risk they have in their portfolio. Then, you help them create a collar around their holdings. The collar will limit the upside potential of their holdings, but will also protect their downside. If they know that the upside doesn't need to be great, but the downside needs to be protected, then this strategy works very well.
There are several ways to approach this process, and we will cover one in this article. Let's say the client has a balanced portfolio of stocks that are representative of the S&P 500. Let's say he has $100,000 of various holdings.
We can sell a call (which is an obligation to sell) of an ETF, or exchange traded fund, that represents the S&P 500 at a price say 10% above the current level. Then we take the premium we receive from selling the call to purchase a put of the same ETF at say 10% below the current level.
Selling the call helps offset the purchase of the put, but even if the cost of the put is greater than the premium we receive from selling the call, we look at the difference as a cost of insuring the portfolio.
When you consider that you insure your health, your life, your car, and your house, shouldn't we consider insuring our nest egg?
This strategy is especially helpful to older clients where wealth preservation is more important than wealth appreciation and something I think more people should consider also in the uncertain economy we have today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.