Ben Felix - Downside Protection | Common Sense Investing with Ben Felix

Short Summary

Main recommendation: Avoid downside protection products such as principal protected notes, and instead hold a low-cost, globally diversified balanced portfolio of index funds, accepting short-term losses in exchange for higher long-term returns. Downside protection looks appealing to emotional investors, but it adds significant costs and tends to reduce expected returns. Ben Felix argues that short-term declines are largely noise for long-term investors.

Key Points

• Stocks outperformed a risk-free investment over 90% of 15-year periods, so short-term market declines matter less for long-horizon investors.
• Risk and return are related: removing risk from an investment inevitably reduces its expected return.
• In a dataset of five-year principal protected notes from a Canadian bank (maturities March 2006 to January 2015, spanning the 2008 crisis), 86% underperformed a simple balanced index portfolio.
• Average return was 1.62% for the principal protected notes versus 4.05% for the balanced index portfolio.
• Downside protection is sold to emotional investors who overweight short-term losses, causing them to act as if their time horizon is shorter than it is.

Details Worth Noting

• Concrete instructions:
  • Minimize costs by favoring low-cost index funds rather than products that add downside protection fees.
  • Capture global market returns by holding a broadly diversified mix of index funds.
  • Control risk through the mix of stocks and bonds, rather than through a protection contract.
  • Be willing to endure short-term volatility: in the balanced portfolio studied, one-year declines of more than 20% occurred in 71% of five-year periods, and every five-year period contained at least one negative year.
  • Scrutinize principal protected notes: they are governed by complex contracts not regulated or reviewed by a securities commission, and their maturities often exceed five years.
• Principal protected notes promise return of initial investment at maturity while participating in an underlying asset group's upside, but the cost of that protection is lower expected return.
• Throughout market history, very few five-year periods have shown significant negative returns, which undercuts the value of downside protection for long horizons.

Bottom Line

Protection from short-term losses is paid for with long-term returns, so for a long-horizon investor the cheaper and more reliable path is a low-cost balanced index portfolio that tolerates volatility.