With memories of last year's bear market firmly stuck in their heads, many investors lately have been looking for investments that offer some form of principal-protecting guarantee. Yet rather than paying the high price of such investments from traditional sources like insurance companies, you can use a do-it-yourself apporach that achieves the same goals -- while letting you avoid paying the costs that would otherwise go to the seller as profits.

Principal protection -- at a price
Recently, I read about an interesting challenge that a financial columnist made with an insurance advisor. The advisor argued that an indexed universal life insurance policy could provide a return in line with the S&P 500 with limited downside risk.

Yet as with many similar products whose returns are tied to stock market indexes, this policy came with some caveats, as the columnist discovered. In particular:

  • The maximum return that would be credited to the account in any given year would be capped at a certain amount. That means that during a year like this one, in which the S&P has risen well over 20%, you might only get credit for a fraction of the overall return of the index.
  • Because the cost of the underlying insurance increases over time, the guaranteed principal protection is only temporary. After a period, it goes away -- and suddenly, you can lose your entire investment.
  • In addition, the return is tied to the value of the index rather than the index's total return. In other words, because dividends aren't reflected in the index's value, you miss out on the extra return that dividends add for those who simply own an index fund.

This last point is actually more important than you might think. For instance, look at just how high the yields are on some of the stocks in the S&P 500:

Stock

Trailing Dividend Yield

Frontier Communications (NYSE:FTR)

13%

Windstream (NYSE:WIN)

8.9%

Diamond Offshore (NYSE:DO)

8.1%

CenturyTel (NYSE:CTL)

7.8%

Qwest (NYSE:Q)

7.5%

Altria Group (NYSE:MO)

6.5%

Reynolds American (NYSE:RAI)

6.5%

Source: Yahoo! Finance.

Overall, the S&P's yield is currently around 2.2%. That's a respectable fraction of the S&P's long-term average return -- and a big reason why the S&P hasn't suffered nearly as dramatic losses over the past few years as you might think simply from looking at the index value itself.

Create your own hedge
One interesting revelation from the challenge, though, was the fact that the insurance companies that create these policies use a fairly simple investing method to hedge their own exposure. In particular, one company insider explained how insurance companies take the policy proceeds and do the following:

  • They buy zero coupon bonds with part of the premiums they receive. These bonds don't make regular interest payments, but they guarantee that the total assets under the policy will be worth at least as much at a certain point in the future as they were when the the customer first bought the policy.
  • With the remaining funds, they essentially make a low-cost investment in a stock index. Sometimes, they'll add bells and whistles by investing in derivatives like index options, but it still boils down to the same general principle.

That's something you can do on your own. With many discount brokers offering bond trading, you can usually find zero-coupon Treasury bonds for whatever maturity you want, ranging out as long as 30 years from now. Then, investing in some combination of index funds, stocks, and options can help you tailor your stock exposure to match your risk tolerance. And best of all, you don't have to worry about losing part of your money to pay a commission or other overhead costs.

Dig deeper
The lesson here is that the more sophisticated a financial product is, the more important it is that you completely understand what's behind it. Often, you may not need all of the features you're paying for. If you want to protect yourself from stock market losses, doing it yourself can help you save a bundle.

Amanda Kish is worried about next year, and she's especially concerned about one sector of the stock market. Find out which sector you should avoid in 2010.

Fool contributor Dan Caplinger is a terrible do-it-yourselfer in just about anything except investing. He own shares of Altria. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't paint your house or mow your lawn, but it'll be glad to stand by the garage and supervise.