How Skittish Investors Can Protect Their Money

Many people invest with Warren Buffett's first rule in mind: Never lose money. That piece of advice has helped insurance salespeople sell billions of dollars of annuities to risk-averse investors over the years. But with just a little extra work, you can create your own portfolio combination that gives you the same protection with a potentially greater upside.

Return of principal, guaranteed
One of the biggest selling points of annuities is the ability to get certain guarantees from the insurance companies offering them. For instance, one popular provision protects annuity investors from long-term drops in the value of their investments, guaranteeing that annuity holders and their heirs will get at least the amount they originally invested in the annuity back.

Until the past 10 years or so, such guarantees didn't have a lot of value. With the stock market tending to move steadily upward, investors expected -- and got -- a lot more than just the return of their principal. But when the Lost Decade hit, those guarantees suddenly looked a lot more attractive to investors.

In fact, the experience of insurance companies trying to deal with the exposure they took on in selling guaranteed annuities shows just how challenging it can be to protect against market downturns. During the financial crisis in 2008, several insurance companies, including Lincoln National (NYSE: LNC) and Hartford Financial (NYSE: HIG), reported large losses related to the steps they took to hedge against the risk that annuity holders would end up collecting on their principal-protection guarantees. Other insurers, such as Manulife Financial (NYSE: MFC) John Hancock unit and MetLife (NYSE: MET), took measures like cutting back on annuity guarantee benefits or raising expenses to try to make up for losses.

Do it yourself
But if principal protection is really that important to you, you can put together a portfolio that will guarantee that you'll have at least as much as you started with. The ultimate no-risk strategy involves two types of investments: fixed-income securities to generate the guaranteed return, and a more aggressive set of investments to give you additional upside.

If you have $20,000 today, you can guarantee that you'll have $20,000 at the end of 10 years by putting a certain amount of money in a 10-year CD today. With such CDs paying rates as high as 3.5%, investing $14,200 today will give you an FDIC-insured $20,030 in 2021. Even if you lose the other $5,800, you'll be certain to have your $20,000 back when the CD matures.

The real question, of course, is what you do with the $5,800. To get returns similar to those of equity-indexed annuities, combining the broad-market stock ETF Vanguard Total Stock Market (NYSE: VTI) with the CD mentioned above would essentially give you gains equal to 29% of the move in the stock ETF's benchmark index. That may not sound like much, but unlike many equity-indexed annuities, the potential gains are uncapped.

Since you're guaranteed your principal back, you may want to be much more aggressive with the $5,800. But that doesn't mean going with leveraged ETFs like ProShares Ultra S&P 500 (NYSE: SSO) or ProShares UltraShort S&P 500 (NYSE: SDS), as the long-term erosion of value from ETFs that focus on daily returns can give you less than perfect results. Instead, an alternative that will give you increased leverage involves using long-term LEAP options to profit from long-term capital gains in the stocks that interest you the most. By using LEAPs, you can magnify your gains well beyond what you'd earn by buying the stock outright.

It's worth the effort
Setting up your own guaranteed portfolio has other benefits. You can undo it whenever you want without annuity surrender charges; CDs carry early withdrawal penalties, but they often pale in comparison to what you'd pay in surrender fees. In addition, by keeping the stock portion of your portfolio in a taxable account, you may qualify for lower tax rates on stock dividends and capital gains -- something annuity holders don't get to enjoy.

The best thing about doing your own strategy is that it's easy to understand. Unlike 100-page insurance documents, buying a CD and making some basic investments is simple, and it gives you the opportunity to put your investing prowess to work. That can boost your confidence over time -- guaranteed!

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