Recently, Drs. Zvi Bodie and Rachelle Taqqu wrote an article in the Wall Street Journal calling on investors to avoid stock market risks. In one example of a way to limit risk, they describe a method using stock options to create a “collar” to limit stock losses. I decided to back-test this idea to see how it would affect investor returns.
In Bodie and Taqqu’s example, they assume an investment in the exchanged-traded fund SPY which tracks the S&P 500 (stocks of the biggest companies in the U.S.). At the time of their writing, a share of SPY was trading at $136.41. You could buy a put option at $116 to limit losses to about 15% over 4 months. To avoid being out the cost of this put option, you could also sell a call option at $143. These strike prices were chosen so that the call and put had the same cost and you weren’t out any cash. The result is that if you use this collar, over the next 4 months you can’t lose more than 15% on your SPY investment and can’t make more than 4.8%.
If these caps on your upside and downside seem a little unbalanced to you, I agree. I decided to dig up some historical S&P 500 stock returns and see what a collar like this would do to returns. In a first experiment, I used 42 years of S&P 500 data starting in 1970. I ran one portfolio without a collar and another with a collar from -15% to +4.8% on the capital appreciation (or depreciation) every 4 months. Both portfolios received dividends. The results for the collar were dismal. Without the collar you end up with $572,000, and with the collar you end up with only $14,400. That’s nearly 40 times less money!
However, this is likely not a fair test because in times of higher inflation the collar was likely shifted a little toward positive returns. In another experiment, I assumed that the collar shifted up when inflation was higher. Essentially, this places the collar at a fixed position in real terms (after inflation). The following chart shows the growth of $10,000 with and without this collar.
The results for the collar are still dismal. Instead of $572,000, you end up with only $67,800. This is a huge price to pay for the comfort of limiting your downside to 15% every 4 months. The collared portfolio only beat inflation by an average of 0.3% per year. In contrast, the S&P 500 beat inflation by an average of 5.5% per year.
The collar that Bodie and Taqqu propose may sound like a good way to protect your portfolio, but you’ll pay a very high price for it over the long run.