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The Wrong Way to Protect Your Portfolio

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Whenever the stock market starts to zig and zag, rather than going straight up, a curious phenomenon happens. Brokers who live off commission income stop touting the endless profit potential of stocks. Instead, they appeal to investors' sense of fear, offering complicated products that promise to protect you from adverse market moves. Unfortunately, these products often don't give you the results you'd hope to see.

The best of both worlds?
The latest financial product to emerge from this trend is called a market-linked certificate of deposit. According to Bloomberg, banks including Wells Fargo (NYSE: WFC  ) , Mitsubishi UFJ 's (NYSE: MTU  ) Union Bank, and Banco Santander-Chile's (NYSE: SAN  ) Sovereign Bank affiliate are stepping up offers for market-linked CDs.

The concept behind market-linked CDs is simple. In return for committing your money for a number of years, the CD gives you a return that's based in part on the performance of a particular market index. Although details differ from product to product, you'll typically earn a certain percentage of the market's advance over the period. But the most appealing attribute is that if the index goes down, you're guaranteed to get at least your principal back.

Anyone who lived through the 2008 bear market understands just how valuable principal protection can be. The problem, though, is that the products' complexity obscures a key fact: Their returns often aren't all that great, even when the stock market does perform well.

Solving one problem, leaving another
The CD format is a bit of a twist for principal-protected securities, but it's a definite improvement over similar products. In 2008, Citigroup (NYSE: C  ) , Morgan Stanley (NYSE: MS  ) , and Bank of America (NYSE: BAC  ) sold almost $100 billion in structured notes, which offered similar terms, but were subject to the credit risk of the issuing institution. One such institution was Lehman Brothers, which left structured noteholders high and dry when it declared bankruptcy.

Market-linked CDs issued by banks can provide FDIC insurance protection, eliminating bankruptcy risk. But the rates aren't all that good, especially considering the risks involved. As Bloomberg describes it, a three-year CD product offers 2.9% interest if the stock market rises in a given year, with no interest if it falls. Given that you can find standard three-year CDs paying 2.4%, it hardly seems worth the risk just to get the potential for an extra half percentage point of yield.

In fact, you can find a wide variety of products that measure their performance against investments other than stocks. For example, one CD offers an interest rate between 0.98% and 5.38%, depending on how an index of commodities performs over the next five years. Top rates on regular five-year CDs now hover around 3%, so while there's potential for upside, you could also be left well behind if commodities don't perform well.

Build your own product and save
If principal protection appeals to you, save money by doing it yourself. With index-linked CDs, companies like Barclays (NYSE: BCS  ) develop the securities, and then the banks that sell them to clients typically get a commission of between 1% and 3%. If the product generates enough profit to sustain such a rich commission rate, you can bet that you're paying more than you should.

Happily, building your own principal protection is easy. Say you have $1,000 to invest. If you buy a traditional five-year CD paying 3% annually, and you invest $863 in it, you'll get $1,000 when it matures. Then, you can take the remaining $137 and invest it yourself, either in an ETF tied to the market you're interested in, or perhaps even long-term options that magnify your leverage if the market moves in your favor. Even if you lose the entire $137, the CD guarantees you'll at least get your original $1,000 back.

It's reasonable to try to tone down your risk when the market gets jittery. But using complex products designed to cater to your sense of fear is rarely a smart move. Sometimes you'll get lucky, but more often, you'll end up paying more than you should for protection you don't need and can build more cheaply and simply on your own.

Profiting when markets fall is the best revenge. Let Michael Olsen show you how to profit from BP's debacle and the Euro-crisis.

Fool contributor Dan Caplinger finds big commission-generating products amusing. He doesn't own shares of the companies mentioned. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always there to hold your hand.

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