The biggest risk of your portfolio not lasting your retirement timeline is if the stock market plunges within the 8 years that you retire, which is better known as sequence of returns risk. This is because historically, when a recession or depression happens, it means a huge market dip that doesn’t rebound fully for a few years.
So, for anyone who has worked in finance, the first solution you think of is pretty simple. Why not just buy puts on the equites portion of your portfolio? A put is an option where you have the option to sell a security at a certain price on or before an expiry date. When you buy a put, you make money on your put when the current security’s market price is below at the price you picked. The price you picked is called the strike price. Since you’re worried about the stock market going down, buying SP500 puts is a great way to hedge against market downturn risk.
While the market is dumping, odds are that your bonds will increase in price due to the Fed lowering interest rates, as they do in times of economic stress, so no hedge needed for bonds. In our case, the bonds you own are treasuries backed by the US government, not municipal or corporate bonds, which would probably not do very well as corporates correlate more with stocks than interest rates and munis can declare bankruptcy (see Puerto Rico and Detroit, amongst others).
SP500 options (SPY) are exercisable anytime before the option expires. They are American-style exercise.
Why is this ideal? If you buy puts and the market dumps 50 percent in a recession, you’ll still have your “starting FI number” because you hedged against a market downturn by buying puts on the SP500. Another way of thinking about puts is buying insurance on a house. Let’s say the house is flooded or burned and only worth half the amount. The insurance company will compensate you to the prior agreed upon price when you signed the insurance contract. You are made whole, just as you would have been in the case of buying puts.
Early Retirement Now did an incredibly thorough series on the SWR and found that sequence of returns is 2 times as important as average returns. Michael Kitces found that the correlation between the SWR and real return rates peak in year 9 and goes down from there. The correlation between year 6 and 9 only increases from .7 to .82 though, so to me it’s not worth it to buy extra puts for years 6-9. Since the longest time period SPY puts are offered for is 3 years, it’s not really worth it for me to buy more than 2 different contracts. Once in year 0, and once in year 3.
To see the prices for puts on the SP500, you need to look at the option chain for SPY. You can do it on this webpage, or any webpage that shows the SPY option chain. Each option contract is 100 units of SPY. So for this screenshot, each contract you buy is worth $27,788 since unit of SPY is worth $277.88. For most people with FI numbers less than $1M, you’d need to buy ~36 contracts at this current price. You would need to buy the contract at the “ask” price — that is the price someone is willing to sell to you at. In this case, buying a put that expires Dec 18, 2020, with a strike price of 280 would cost you $29.99 per unit of SP500. The cost to buy the contract would be $2999. A simple way to think about it would be that this insurance will cost you 10 percent over the course of 3 years. 3 percent a year for equities insurance isn’t terrible if you only need to buy it for a few years to fend off a market downturn.
Potential Risks & Downside
The options exchange (CBOE and CME) go out of business. Likelihood: Extremely extremely unlikely. The CBOE and CME have a member based clearing structure. The biggest banks have “bought” into the clearinghouse by putting up a lot of capital in case one of its members fails. Even before that the seller of the contract ponies up margin each day whenever the price of the option moves in your favor. Even after all those safeguards, I believe the US government would let a bank fail before an exchange or clearinghouse. Since there are so few large exchanges for derivatives (3, by my count), I highly highly highly doubt that the government would ever let that happen. There are about 10 large banks, so letting a few fail isn’t the worst thing (I know it was bad, but it could’ve absolutely been so much worse). If that happened, there would be catastrophic consequences for any derivative markets and just financial markets in general.
You’ve spent a 10 percent premium on your put option. 3 percent insurance per year to protect your equities is not atrocious in my opinion. You would also miss out on the returns for the premium that you just paid. On the bright side, you’re now enjoying a “loss” on the premium you paid in year 3 if it expires worthless. If the market has appreciated considerably, congrats! You get to net that against your gains for the year and carry the rest of the loss forward. You can carry losses up to $3k per year until you run out of losses. If the market has gained in the last year of your option, it might be worth it to net it against your gains if you’re in a 15-20% LTCG bracket.
For simplicity, we’ll take the 75/25 split the Trinity study recommends for stocks and bonds. You’re only paying the premium on the stock portion of your portfolio, not the entire thing. So the premium on your current FI number is 7.5 percent.
Looking at the market returns for the SP500 and just even eyeballing, the market has dumped no more than 50 percent over a period of 1-3 years. There aren’t any flat years (less than 2 percent gains) in a row, and the market has only actually had 4 periods where there was more than 1 down year in a row. There are 14 periods, with much longer streaks where the market has been up consecutively.
I’m not saying there couldn’t be a down period that is a decade long. There absolutely could be. Anything is possible. But if you read my post on why the SP500 is not the Nikkei, you can see why I don’t think the US market would have more than 2-3 down years in a row at most.
Will I enact this scenario prior to my retirement? It depends on when the market finally takes a nose dive. I don’t plan on being financially independent for another 5-10 years. If the market dives before my retirement years, then I probably wouldn’t buy put options. If it still hasn’t taken a dump 2 years prior to my retirement, then I would highly consider it. If it still hasn’t by the time I’m financially independent in 5-10 years? Absolutely.
What are some strategies you’ve considered for sequence of returns risk? Is anyone planning on employing some kind of strategy right before they become FI?
Portions of this may be unclear, so if you have any questions please feel free to ask. Some of these concepts might need a longer blog post, so please let me know and I can revise on it for the future :).
*I’m not guaranteeing the strategy will work nor is this a recommendation. It is simply my opinion. Please read the legal disclaimer in the “about” section.
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