Even though they experienced the hazards of stock ownership firsthand in 2008, investors are venturing back into equities again. They've been advised that there's no other way to make up the losses they suffered—or meet their looming retirement requirements—and, not to worry, the risk of stocks diminishes the longer you hold them. The Federal Reserve, meanwhile, has announced that it intends to keep interest rates low through 2014—providing a powerful inducement to stay in stocks since bonds will probably generate unusually low returns.
The desire to get back what you lost is understandable. But, as behavioral economists have shown, it can also cloud your judgment and lead you to take more risk than you can handle.
Despite the assurances of the financial industry, stocks are always a risky investment, and the longer you hold them, the better your chances of getting blindsided by a downturn. The usual way of mitigating that risk, diversification, holds no guarantees, either—for the simple reason that investments don't always move the way we want in relation to one another.
A safer way to build and protect retirement assets is to picture your goals as clearly as possible. Then pare things back to the basics. Figure out the bare-bones level of income you need and invest in products that guarantee it, such as inflation-protected bonds. Use the rest of your investment money to build reserves to fund your aspirational goals.
But when you're aiming to meet your aspirational goals, there is a way to limit your downside risk—by using instruments that let you limit your losses at the cost of some upside potential. You can do this through direct purchases of options, or you can buy mutual funds that use complex hedging strategies. These funds aren't as transparent as stocks, but their aim is to protect your money from disaster.
A Hard Look at Stocks
It may be hard to let go of the belief that buying and holding stocks is a sure-fire key to asset growth. But that's because people have been lulled into thinking that long-term stock investing greatly reduces the risks. The truth is that stocks are risky no matter how long you hold them.
Yes, equities can be expected to produce a superior average return in comparison to safer investments. That's as it should be, because the higher return compensates investors for taking the added risk. But this does not mean that stocks become less risky over long time horizons.
There are a number of different approaches that demonstrate why the conventional wisdom about stocks is wrong. One of them has to do with bear markets, which happen regularly; the long growth stretch that began in 1983 and lasted through the 1990s has not been the norm. And the longer you hold onto your stocks, the greater your chances of running into one of those downturns.
Even with the long boom, bonds outperformed stocks over the 30 years since the fall of 1981—delivering an average annual return of 11.5% vs. 10.8%, respectively—with less risk and less volatility than equities.
To prove their claim that stocks are not very risky in the long run, stock enthusiasts argue that stocks have beaten bonds for every 30-year period starting in 1861—except for the most recent one. But their evidence is much thinner than it appears: Since 1861, there have been only five non-overlapping 30-year periods! Statistically, that's simply too few independent periods to justify the conventional conclusions.
What's more, the idea that "stocks do well in the long run" isn't a practical guideline for individuals. For one thing, the "long run" means something different to different people depending on their ages and goals—for some, it's 10 years, for others 30. And while the odds of getting good stock performance over that time are good, the consequences of a downturn can be severe, depending on how steeply markets decline, how much you have in the market, and when the downturn hits in your lifetime.
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If you're expecting stocks to outperform, say, 70% of the time, you need to think about how much you stand to lose the other 30% of the time. It does not do you a lot of good to have 20 years of great performance, only to be trounced in a crash just before you retire.
The usual way of protecting a portfolio—through diversification—is sensible and advisable. But it's hardly a guarantee. Diversification aims to provide stability by mixing up different classes of assets, which are expected to behave differently in different circumstances.
Yet the correlations it's based on aren't constant. Bonds and stocks have moved in opposite directions at times, but in other periods they have not. And foreign markets are growing less and less decoupled from the U.S. Recently, prices of assets as diverse as large-cap domestic stocks, emerging-market stocks, oil and gold have been fluctuating together rather than in counterpoint.
A Safer Strategy
What's a better approach to building a portfolio? First, forget the idea of "catching up." Most of us find loss so painful that we're willing to go out on a limb just to recover what's gone. We're willing to take risks we'd normally avoid to recoup what we see as rightfully our own.
Instead, when you start by looking at your destination and focus on what you absolutely need, you protect yourself from missing your essentials if the market falls short. And you steel yourself against a blind obsession with recouping loss.
Separate your basic must-have needs from your aspirations or wants, and create an investment plan that guarantees the basics with inflation-protected, safe investments. You may be surprised at how much less you need than you want, but try hard to be honest with yourself. Then put any other investment dollars you have available each year into riskier vehicles to meet your aspirational goals.
Intuitive and straightforward as this approach may seem, it's not commonly pursued by most investors and advisers. Assessing what's really necessary takes time and reflection. Few people do it systematically, if at all.
Once you decide how much money you need for your basics, create a safety net to guarantee that you can cover them. That's where securities that protect against inflation—such as TIPS and I bonds—come in. (Although many people include insured bank certificates of deposit in this mix, CDs don't provide inflation protection.)
For the best safety net, put together a "ladder" of TIPS, held in tax-deferred or tax-exempt accounts. Figure out how much money you need each year, then invest in TIPS with maturities that match your future spending dates. Your plan won't be perfect, of course: Your personal rate of inflation may not match the Consumer Price Index, taxes may intervene, and life happens. But don't let the perfect be the enemy of the safest available choice.
Today's low-interest-rate environment poses some difficult challenges even with a bare-bones safety net in place. Today, TIPS and I Bonds do not yield more than the rate of inflation. And many people are starting practically from scratch, whether because the market collapse set them back enormously, or because they have not managed saving much for retirement yet.
It's impossible to generalize about every investor's situation, but many households are probably facing the prospect of a very small safety net in retirement.
With that outcome in store, many people may be tempted to gamble on riskier investments to meet their retirement needs. But your safety net is meant to be the money you can count on. By definition, you don't want to put it at risk. If you bet your basics in the market and lose, you can easily end up worse off, with less to spend on your essentials.
If you don't think you can create a safety net that's big enough, there are other steps you can consider, although they can be tough. You might spend less today to save more for tomorrow. You might work extra jobs, move to a higher-paying career or retire later. You can also try scaling back your definition of needs.
How low can you imagine turning down the jets if need be? Is a community college a viable alternative for your child's first two years out of high school? Can you lower your expenses in retirement by moving to a less-expensive location, downsizing your residence or traveling less?
It's this kind of assessment that should be driving your risk decisions. It requires careful and honest introspection, as well as a lot of consulting with the key partners in your life.
Limiting Your Risk
Now that you've separated your needs from your wants, you can decide how much to limit the risk you take with your aspirational investments. If you've lived through 2008, you probably don't want to see losses of 30% to 40% ever again.
There are several ways to protect the money outside your safety net. For instance, there are investment products that protect either principal or income by using hedging strategies involving various combinations of derivatives.
But you must be careful to read the fine print. You need to understand the managers' strategy in detail, including which risks they're hedging and which risks remain unhedged. It's also important to weigh a fund's expenses, both embedded and explicit. The costs of these transactions can be high, so do look carefully at the expense ratios of the fund along with all its fees.
Investors who are more seasoned can undertake some of these complex strategies on their own. For instance, when you buy an investment such as the S&P 500, you can buy a put option on it, too. This gives you the right (but not the obligation) to sell the investment at a future date at a price you determine at the time of purchase. Since your investment can't fall further than the "strike price" you've selected, you're effectively setting a floor on your losses.
Let's say you buy SPY, an ETF that tracks Standard & Poor's 500-stock index, at its recent price of $136.41. You're willing to sustain a 15% loss, but not more, so you buy a put with a strike price of $116. Since you can now sell SPY at $116, you're protected in case it drops any lower. Essentially, you have bought insurance with a deductible of 15%; that's all you can lose.
Is it worth it? The put in this example, which expires in four months, would have cost $2.16 at the time you priced and bought your ETF shares. But the good news is that there is a way to avoid the cost of the put, by trading away some of the upside of your SPY shares. You can sell a call on your investment. This means that you are selling someone else the right to buy it at a stated strike price on or before a future date. If the shares reach the strike price, you are obligated to sell.
In order to end up with a near-zero cost for your options, the prices of the put and the call will have to be roughly the same. In our example, there is a four-month call that is priced at $2.17—close to the $2.16 you paid for your put—and it has a strike price of $143.
When you sell this call, your proceeds fully offset the cost of your put. If the value of the ETF rises before the option expires, you get to keep everything up to $143. But not more than that: Your gains beyond $143 have been traded away. So the strike price of the call you sell is the upper bound on your potential gain.
In this strategy, called a zero-cost collar, your costs are limited to your transaction costs alone, since your proceeds from selling the calls will zero out the cost of the puts. And your investment outcomes are now limited as well: In this case, you can't lose more than 15% on the downside or gain more than 6% on the upside.
If you want to increase your potential upside and still have the costs cancel out, you'll need to lower your floor. In our example, you can increase your potential gains to $147 if you are willing to take losses all the way to a lower threshold of $108 (that's a loss of just over 20%). It's akin to increasing your deductible on insurance in exchange for a reduction in the premium you pay.
For the most part, "structured" products for limiting risk are still on the drawing table. They remain to be perfected. But the notion of sacrificing a limited amount of safety in exchange for upside potential is profoundly relevant to retail investors' needs right now.
So keep your eye out for them: It should not be long before growing consumer demand transforms them from next-generation investments into products whose time has come.
Drs. Bodie and Taqqu are co-authors of "Risk Less and Prosper: Your Guide to Safer Investing." Dr. Bodie is the Norman and Adele Barron Professor of Management at Boston University, and Dr. Taqqu is a financial consultant in the Boston area. They can be reached at reports@wsj.com.