The starting point of my journey in personal finance and investing was trading. Trading was my first love. This is the reason why I only recently had a look at annuities; for a long time, I considered the instrument as ‘too boring to bother’ and an area so full of scams that rendered any research useless anyway.
I find annuities intriguing because they are the financial opposite of life insurance: while life insurance is all about people you love, from a beneficiary point of view, with annuities you are the focus. Thanks to my life insurance, if I would die tomorrow my wife would be a millionaire (just do not tell her). If I had invested in an annuity instead (which is not 100% accurate because my employer pays for my life insurance), I would guarantee myself a stream of cash flows that I cannot outlive, but in the case I prematurely die my family would get nothing and my investment would be lost.
Annuities look like the most selfish investment possible. I wonder if there is the possibility to structure a “family contract”: I will invest in an annuity contract but with my sons, so that if I die they will get some money but if I outlive the money pot, they will have to provide for me. But this is probably something for another day.
Given my curiosity about the instrument, I paid a lot of attention to the Animal Spirits podcast episodes with Halo Investing. Actually, this post is not about annuities but another topic those conversations brought to my mind. In December 2020, the co-founder of Halo Jason Barsema joined Michael and Ben and explained how annuities are great to provide higher than ‘expected’ (by the general public) fixed returns when rates are low. This is possible because annuity returns are the sum of two components: interest rates and “mortality credits”. Mortality credits are essentially the excess payments that are left behind when other annuity owners invested with your insurance company pass away. These payments depend on actuarial tables, how long we are supposed to live statistically speaking, and are not correlated to any financial variable like interest rates. Since life expectancy increases quite slowly (it even went down recently due to Covid), this annuity return component is steady and becomes more and more relevant the more the interest rate component goes down. So according to Jason, if rates are low annuities are great thanks to this kicker in returns.
Jason returned to the podcast a month ago and Ben asked him how annuities are doing now that rates went up. This time, his reply focused on the other component of annuity returns: rates up mean annuity returns are up, it is a great time to invest in annuities!
…again?
No Free Lunch
Based on Jason’s interviews, you would think that whatever the interest rate regime, it is always a good time to buy an annuity. Based on your circumstances, it might indeed be the case. If you are fine with the agreed annuity pay-out in 2019, would you regret your decision knowing that if you postponed it for a couple of years you would have locked a substantially higher income? Maybe interest rates would have gone further down instead of up, who knew?
As for the person who prefers to pay down their mortgage as fast as they can, we should take into consideration the peace of mind component of certain decisions that are not ‘financially optimal’. But I think we should not completely overlook all the possible scenarios and consequences of those decisions.
In the annuity case, here is a great post by Kitces that quantifies how (fu**ing) expensive can be a retiree’s peace of mind (and for their family as well). And here is a great post by Finumus on a tangent topic, i.e. why you should borrow money if the debt is canceled under some life-defining events (student debt in the UK).
Let’s explore the ‘dark side’ of other financial strategies that seems to bring only positives to the table.
Covered Calls
I already wrote a long post about covered calls here. In short, selling calls on the S&P500 while being long the index has provided, in the past, better risk-adjusted returns than the buy&hold alternative. For this reason, the strategy has been adopted by a lot of market participants that want exposure to stocks but cannot stand the volatility.
There are two issues in pursuing ‘blindly’, i.e. without checking market conditions, this strategy.
The first is that the premium you get from the calls changes over time. It is really difficult for the untrained eye, non-professional volatility investors, to judge how much upside you are giving away for the premium you get but it has to be clear that at a certain point, the game is not worth the lost opportunity. Lately the trade has become so crowded, with many investors chasing the same strategy, that premiums are too low to bother.
The second is that the strategy works better in markets where ups and downs are not extreme. I honestly do not remember if the classic strategy sells ATM or OTM calls but anyway, the less the index rip on the upside, the fewer gains you give away. Same on the downside: if the index drops 1% each month and you get 20bps of monthly premium, by the time it gets to -30% your strategy is down -24%. If it takes the index a couple of months to go to -30%, your strategy’s loss is almost identical. In this context, a market characterized by “V shape” recoveries is the worst possible scenario, because the covered call strategy does not protect you on the downside but prevents you to get exposed to the index bounce. Guess where the market is going?
Michael Green explains it well in this podcast episode. The raise of passive investors have changed stock index returns distribution in two ways: median returns drifted to the right, up days are more frequent and the daily increase is bigger, but the left tail got bigger too. So, bigger ups and bigger downs.
For the record, not everyone agrees with this theory, Cullen Roche is the most prominent example that I know. But if you look at recent downturns in 2018, 2020 and 2022…I would be more inclined to believe in it than not.
As for the annuity example, the covered call investor would always have it “their way” because, no matter the market, they will effectively experience lower gains and lower drawdowns…even when they gave away too much for too little peace of mind.
Hold cash to take advantage of bear market opportunities
There are various ‘shades’ of this strategy but they all basically revolve around market timing. The investor holds a cash reserve that deploys at certain defined conditions, like the stock market dropping 20% or 30%. The main advantage of this strategy is psychological: defining a 20% decline as a buying opportunity while stocks are steady, helps the investor to react in a positive way when the market crash happens. For sure, this investor is less likely to panic and sell during a crash.
The strategy brings some ‘conversational bragging points’ as well. The investor is more likely to discuss it during a bear market, sounding like a genius to their friends for having foreseen the crash and coming prepared for it.
In reality, the best moment to buy stocks is “now”. Any market timing tentative will result in lower returns. If you want a deep dive into the reasons, here is a collection of posts from Nick Maggiulli. But again, if for your peace of mind you still want to pursue this way, I would suggest a more structured approach. The rebalancing process of an 80% stocks – 20% cash portfolio (or whatever %s fits for you) achieves the same objectives without leaving the investor the arbitrary decision of defining when the stock market is ‘overvalued’ and therefore is better to stash cash into the reserve instead of buying. The % declines that trigger buying orders are arbitrary as well: swing only for the fat fences (-30% and more) and the investor might stay in cash for ages, swing earlier and they are going to stomach a -50% fully invested while cursing why they did not wait to act.
Sell puts on your favorite but overvalued stocks
The investor likes stock XYZ, the business and the outlook, but at the moment the stock is trading at a high valuation. To achieve the best of both worlds, the investor sells an OTM put on stock XYZ at a strike that represents a cheaper valuation: if the stock goes up the investor collects the premium, if it goes down the investor gets the stock at the price they wanted. What can go wrong?
A couple of things. The strategy offers the investor a defined upside for unlimited risk. If the investor is too conservative in their valuation, i.e. the stock is fairly priced now, it can double from where it is while the premium the investor got is just a few % points gain. They basically morphed into a credit investor holding the wrong instrument in the capital structure. All of this while spending resources to perform the research on the name.
The biggest risk for the investor is that the stock he gets assigned is not the stock they wanted. What I mean is it if the stock drops for unpredicted reasons, like an accounting scandal, that was not part of the investor analysis. If the investor monitor a stock and an idiosyncratic black swan event happen, they can always revisit their analysis and move on if the new information invalidates the original thesis. When the investor sells the put, they already took a commitment.
This strategy stops making sense when investors fall 100% in love with it, i.e. they become so greedy that no price is low enough and instead of buying a stock that is already cheap, they continue to sell puts. Facebook Meta is a great example right now. Trading at 15 P/E, it is already discounting multiple future metaverses where the metaverse bet does not pay out. To me, the metaverse bet is pretty digital: if Mark is right, the stock is worth a lot more; if it doesn’t deliver, the stock is toasted. Selling OTM puts, given their risk profile, is not the play here.
The idiosyncratic risk is by definition null if I sell OTM puts on an index like the S&P500 (yeah yeah, the US, blah blah blah, do you remember when S&P stripped them of the AAA rating? If the US loses, we are all gonna lose badly anyway). So let’s say I invest 5% of my 60/40 portfolio in a 20% OTM put on the S&P with one-year maturity instead of bonds. It is a kind of bond substitute because I get a fixed 3.2% return (but with a very low duration, while the standard 40 part is 10 years Treasuries, so to really compare the two strategies you have to increase the duration of the remaining 35%). If at maturity the option is in the money, the S&P500 lost more than 20%, in both cases I would have to sell bonds to buy stocks. The comparison is not easy since if stocks go up, I can buy the option back and get the premium ‘for free’, while if stocks crash more than 20% I would lose the opportunity to reposition the portfolio at an even lower price (but I doubt I would not start to rebalance after a 20% dip anyway). On an even more tangent note, I cannot hold bonds in my IB account for tax reasons but options are 100% fine so…. Anyway, just an idea I am tinkering with these days after the Halo podcast episode.
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