Here’s my latest get rich slowly scheme for investing in the stock market. I largely agree that individual investors can’t do better than the market index over the long-term; therefore, it’s a good idea to stick your money in index funds and rebalance occasionally. If you look at index investing over a long time period, there are short periods of gains and losses, and long periods of meandering growth that just earn dividends. It’s important to have your money in the market to catch those periods of high growth. However, you’re also stuck when the market crashes. So my goal is to cushion those infrequent sharp market crashes.
The idea is to invest in an index ETF and buy deep out-of-the-money (LEAPs) put options as insurance for those big drops. The S&P500 Spider ETF (SPY) is at $111 and a put option expiring on June 2011 at 100 is $6.50, at 90 is $4. These put options protect against a 10% and 20% drop respectively, and will rise even if the market falls just 5-10%. Unfortunately these options cost 5.8% and 3.6% of your investment for ~10 months of protection. The yield on SPY of 1.9% offsets the cost somewhat, but you still begin with a 3.9% or 1.7% loss every year. That puts you in the same league as mutual funds which charge 1% in fees and on average earn 1-2% less than the index.
To do better you can improve the yield by buying a collection of high-dividend stocks that together track the S&P500. I don’t have the reference that explains this, but 10-20 stocks spread across sectors should do it. This might boost the yield to around 3-5% and cover the cost of the put options. You can also sell short-term call options to earn a little extra change to cover those puts. The tricky part is constructing a basket of stocks to track the index and maximize dividends. The other tricky part is buying the put options: should I just buy LEAPs or can I use some kind of laddering technique (but options at different expiry dates). I’m sure this has all been done before, so I’ll just search for a solution.