August 7, 2009

Fixed, Indexed to market or Direct market

Lets compare three different kinds of investments. The three investments are fixed interest investment, an investment that has its returns indexed to the stock market and direct investment in stock equities.

Fixed investments
are pretty simple. A good example of a fixed return investment is a bank CD or a bond. You buy the investment as an IOU and they pay you a specified fixed investment for the given time period. Theres no risk or minimal risk, but the returns are limited compared to riskier investments.

Directly investing in the market is also fairly easy to understand. You take your money and buy shares in a mutual fund or index fund. If the market goes up you profit, if the market goes down you lose. Theres higher risk and higher potential returns.

Indexed investments are more complicated. These are investments where you invest your money and then your return depends on the performance of the market. The appeal of an indexed investment is that your risk will be limited as well. So you may get an investment for example where you are guaranteed not to lose any of your principal but you'll get 50 or 80% of any gains in the S&P 500. Here are a couple explanations of ways you can index your returns to the stock market while protecting your principal: Bad Money Advice describes doing it with options: Principal Protecting Your Investments and the Oblivious Investor does it by using growth to directly buy an index fund : Principal Protecting Your Investments

Lets say that the returns of the 3 options look like this for a given period:

Fixed Indexed Direct market
1990 5.00% 0.0% 3%
1991 5.00% 2.9% 9%
1992 5.00% 3.2% 9%
1993 5.00% 0.4% 6%
1994 5.00% 0.0% 2%
1995 5.00% 13.2% 23%
1996 5.00% 6.6% 14%
1997 5.00% 33.2% 49%
1998 5.00% 9.3% 17%
1999 5.00% 10.1% 19%
2000 5.00% 1.9% 8%
2001 5.00% 0.0% -15%
2002 5.00% 0.0% -25%
2003 5.00% 2.7% 9%
2004 5.00% 4.6% 11%
2005 5.00% 5.2% 12%
2006 5.00% 0.0% 3%
2007 5.00% 6.7% 14%
2008 5.00% 0.0% -13%

Or graphically the annual returns are:

The averages are fixed = 5%, indexed = 5.27%, market = 8.1%. The maximum gains seen were fixed = 5%, indexed = 33% and market = 49%. The minimum one year performances were fixed = 5%, indexed = 0% and market = -25%.

So with the indexed fund you can experience up to 2/3 of the market returns but be guaranteed not to lose any principal. Would you take the indexed fund over the direct market? Given this explanation to me it seems tempting.

The real measure of any investment is how much money you end up with compared to how much you start with. Lets look at how well each of the 3 investments would have done if you put $10,000 into them:

As you can see the purple line representing direct investment in a S&P 500 index fund would have outperformed both the fixed and indexed investments. Probably more striking I think is how the indexed investment performed virtually the same as the 5% fixed investment. Given the investments described above the fixed and indexed investments end up about the same.

I should point out that the dates picked were somewhat arbitrary. The figures are numbers and the market performance are meant for illustrative purposes to compare these styles of investment. Of course market returns can be better or worse than this example. If you bought in 1999 then held through 2009 then the fixed investment would have outperformed the other two alternatives and the indexed which would have beaten the direct index fund investment.

Whether the markets perform well or poorly the returns from an investment that is indexed to the market are not likely to be better than a simple straight forward fixed investment.

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