The Tradeoffs Between Risk & Return

When it comes to investing, small changes can have extraordinary impacts.  For example, imagine a hypothetical investment that would:

• Appreciate by the return of the S&P 500 price index up to a cap of 10% on a year-over-year basis; and

• Never lose money over that same period if the S&P 500 was down.

If the S&P 500 price index was up 5%, the investment would be up 5%. If the index was up 20%, because of the cap, the investment would only return 10%.  However, the investor can never lose money. If the market is down 30%, he will still be where he started.  The investor begins every year knowing his returns will be somewhere between 0% and 10%.   

Is this a good long-term investment?

In the below chart I compare the price return of the S&P 500 to this hypothetical investment.  $10,000 invested in 1960, tied to the annual price returns of the S&P 500, with no caps or floors, finished 2023 worth $796,303.  The same money allocated to the capped investment that couldn’t lose money finished with $446,982.  Taking risk off the table smoothed the investor’s volatility but cost him hundreds of thousands of dollars.

Data Source: https://www.slickcharts.com/sp500/returns/details

But that is not the worst part. 

The return on this hypothetical investment was based only on the price change of the S&P 500.  It completely ignored dividends.  Had the investor instead used an investment that tracked the S&P 500 total return index (one that includes the change in price plus the dividend income) his returns would have been $4.6mm higher.  [assuming zero taxes, fees or tracking error.]      

Data Source: https://www.slickcharts.com/sp500/returns/details

Data Source: https://www.slickcharts.com/sp500/returns/details

“Of course the investor that received dividends made more money than the one that didn’t,” you might say. “That is obvious.”  But maybe the magnitude of the difference isn’t so obvious, because every year hundreds of billions of dollars get allocated to investments entirely focused on price return. 

Fixed indexed annuities, structured products, and buffered ETFs (also referred to as defined outcome ETFs) are a few of the more popular examples that all fall into this category.

A few caveats:

Every trade has risk and not every investor can stomach the thought of seeing their equity portfolio drop by 50%.  I recognize a strategy of maximum volatility is not right for everyone. However, my goal here is to help long-term investors understand which risks they are taking, and realize that small changes - like missing out on dividend payments or hedging against loss - can have massive, multi-million dollar, impacts over time. 

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I don’t want to get into the compliance weeds of discussing specific complex securities (and this is certainly not a recommendation to buy or sell) but if you would like to take a look at an example of a buffered ETF that looks similar to the hypothetical investment I describe above, check out ticker MAXJ - iShares Large Cap Max Buffer Jun ETF - a fund that promises a starting cap rate of 10.64% and 100% downside protection, tied to the price return of the S&P 500.

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For a similar discussion, see last week’s post explaining what would happen if you invested only when your preferred party was in the Presidential office as opposed to staying fully invested all the time.   

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Click here if you want to see the spreadsheet with the annual data I used to create the charts.

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If you have made it this far, in hopes of finding some non-financial content, here is a picture of our two current foster dogs: Smooshy & Avocado.

They were just two of seventeen dogs taken in by Jenni’s Rescue Ranch from a single bad situation. They’ll be rehabbed and available for adoption pretty soon. If you are ever interested in fostering, adopting or rescuing, Jenni’s is a good place to start.