No. of Recommendations: 7
Executive Summary
The time period under consideration had two bear market crashes, when the market had a 50% loss.
The IUL-type strategy avoided those crashes, but at the cost of delivering substantially less overall gain.
One test was run where the last 10 years had a $1500 monthly withdrawal. By coincidence, the start date for the withdrawals was at the bottom of the first crash. Even so, the IUL-type strategy had a lower return.

An alternative strategy was also tested, which uses a simple timing signal to move in and out of the S&P500. This strategy has less volatility than the S&P, but higher volatility than the IUL strategy. It delivered a better overall return than the IUL strategy.

The IUL-type strategy is claimed to deliver market-like performance without market risk. It does not. It does eliminate market risk, but it has nowhere near market performance -- except perhaps in the short-term.

After a suitable time to allow for comments & discussion, I will upload the spreadsheet for public access.
------------------------------------------
Here are the assumptions:
S&P500 index from 1/1/1975 to 1/1/2013.
This is a period of 38 years, or 456 months.
Assumed dividend yield: constant 2.25%

Secondarily, the 2nd half of this period is also computed.
7/1/1993 to 1/1/2013

Initial deposit (purchase) of $10,000
Subsequent deposit (purchase) of $100 each month. ($1,000 per month is much too high.)
That's a total of $55,600 over the 38 years.

The IUL-like rules are:
Index only, without dividends.
Floor of 0% annual return.
Cap of 12% annual return.
Annual fee: 0.00% (This is the most optimistic fee. A fee of 0.50% was distinctly worse.)

For the market-timed strategy, cash earned 1.0% interest when out of the market.

For the Sortino Ratio, the MAR is 3%.

No taxes are considered.
No trading fees are considered.

------------------------------------------------
Three strategies were compared.
1) Buy-and-hold of the S&P500 index, including dividends.

2) Market timing overlay on the S&P500 index, including dividends.
Each month, compute the 10-month simple moving average (SMA)
Buy when the S&P index is >= the SMA.
Sell when the S&P index is <3% below the SMA.
This turns out to be about 0.4 trades a year, with an average hold time of 715 days.

3) IUL-type modified annual returns.
If the S&P500 index return is < 0%, deliver 0% return. (0% floor)
If the S&P500 index return is > 12%, deliver 12% return. (12% cap)

Explantion of the below statistics.
CAGR = compound annual growth rate. Higher is better.
StDev = volatility of the returns. Lower is better.
MaxDD = maximum drawdown. The worst dollar loss from the 12-month high. Lower is better.
Sortino Ratio = a figure of merit, measures shortfalls of returns below the target MAR. Higher is better.
Initial to: The final value that the initial deposit (only) has grown to.
Final value: Final value including initial and monthly deposits and withdrawals (if any). Higher is better.

Note this: S&P500 B&H with and without dividends:

S&P B&H w/div
CAGR 10.7%
Initial to: $478,263
Final Val $932,426

S&P B&H EXCLUDING dividends
CAGR 8.3%
Initial to: $206,683
Final Val $444,769

Excluding the dividends cuts the final value in half.
That's a large headwind for an index-only strategy.

The statistics of the three strategies.

S&P B&H w/div
CAGR 10.7%
StDev 15.3%
MaxDD -46%
Sortino 0.66
Initial to: $478,263
Final Val $932,426


10mSMA
CAGR 9.8%
StDev 12.1%
MaxDD -25%
Sortino 0.72
Initial to: $348,844
Final Val $773,118


IUL floor/cap
CAGR 6.9%
StDev 1.7%
MaxDD 0%
Sortino 11.49
Initial to: $123,904
Final Val $337,235

A sortino ratio of 11 is excellent. That's the result of having a 0% "no-loss" floor. The tradeoff is that the total return is substantially lower -- only 1/2 or 1/3rd of the other strategies.
Equity curve: See chart 1
http://i1131.photobucket.com/albums/m543/rayvt/chart-1_zps8f...

Chart 5 is the same, except the scale is adjusted so that the period from Jan-1975 to Jan-1997 is more visible. The Oct-87 Black Monday crash is quite apparent. That was a -30% loss in just 3 months time.
http://i1131.photobucket.com/albums/m543/rayvt/chart-5_zps8e...

Second half -- Jul-1993 to Jan-2013

S&P B&H w/div
Final Val $94,202


10mSMA
Final Val $108,312


IUL floor/cap
Final Val $85,487

Equity curve: See chart 2
http://i1131.photobucket.com/albums/m543/rayvt/chart-2_zps3a...


For comparison, the full period with no monthly deposits:

S&P B&H w/div
Initial to: $478,263
Final Val $482,219


10mSMA
Initial to: $348,844
Final Val $351,493


IUL floor/cap
Initial to: $123,904
Final Val $124,570

Equity curve: See chart 3
http://i1131.photobucket.com/albums/m543/rayvt/chart-3_zps9e...

=================================================
A 28 year accumulation, $10,000 initial + $100/mo from Jan-1975 to Jan-2003, then withdrawing $1,500/mo from Jan-2003 to Jan-2013.
This is an 11% annual withdrawal rate based on the IUL value on Jan-2003 ($162K), which is far higher the customary Safe Withdrawal Rate of 4%.

S&P B&H w/div
Final Val $671,380


10mSMA
Final Val $516,945


IUL floor/cap
Final Val $65,453

Equity curve: See chart 4
http://i1131.photobucket.com/albums/m543/rayvt/chart-4_zpsbf...
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I think the major point is taken a little out of context. Everything has its proper time and place. Obviously over the long haul, IUL will underperform. But, say someone retires and a) has a short time horizon due to health or family history and b) can't afford to lose either financially or emotionally. In those limited cases, I think IUL has its place.

For me personally, I don't think IUL will be part of the program.

JLC
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Ray,
Thanks for going to the work... but something is awry.
Without even digging in, its easy to see from the charts that, at minimum, the IUL was calculated wrong.

Can you email me (or put up here via Dropbox public share, or imilar) your Excel workbook?

I'll take a look, and/or build my own from scratch... but advance warning/apology that I'm particularly swamped this week, and taking the family to Mexico for a vacation next week, (with the requisite catch-up period upon return,) so it could very well be up to 3 weeks before I get to roll up my sleeves & iron this out for us all.

*GAURANTEED* that I will, however...
Fortunately, threads typically don't expire or disappear ;~)

Dave Donhoff
Leverage Planner
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No. of Recommendations: 3
I just want to thank Ray and Dave for both educating us about retirement investment strategies. Even if I don't use an IUL now, I know it exists and have that knowledge in my back pocket. To JLC's point, as I draw closer to retirement, I will probably start migrating percentage of my portfolio towards one or more IUL plans. To me it represents a much better fixed income option than bonds do. I couldn't imagine retiring today and having to worry about the bond bubble.
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Ray,
While I was at the gym, I realized there's something else out of whack on the naked S&P side. When you can, do share up a method of downloading your Excel file, and I'll grind through it.

PS. as a point of reference, how much in non-risked reserves would you advise a person keep when going naked in the securities?

Thanks!
Dave Donhoff
Leverage Planner
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While I was at the gym, I realized there's something else out of whack on the naked S&P side.
What a coincidence -- when I was at the gym I realized a simple way to do all rolling 12-month returns. And, as you said, something was wrong with the IUL figures I posted.

Doesn't change the big picture, just makes it less bad. ;-)

I came up with a simple sanity-check spreadsheet. I believe the computations are correct, but please y'all take a look and see if you spot any errors.


Dang, all the free file sharing sites I used to use have all disappeared.
I send it to this open email site: http://www.yopmail.com/en/

Just enter " iul-spreadsheet " as the address and hit "Check Inbox." No login or registration required.
They say it will stay there for 7 days, so grab it fast.
Any corrections? Just email your updated sheet back to there.
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They say it will stay there for 7 days, so grab it fast.
Got it, thanks!

Any corrections? Just email your updated sheet back to there.
I'll prolly stick it in my DropBox Public Share folder & post the link.
Accessing it is free, no subscription required, and it won't go away unless/until I delete the file from the folder.

Its a pretty slick secure share system...
If you don’t have a FREE Dropbox account yet, get it here; http://db.tt/FaHeiIt
(Yeah... my own premium account memory grows when others sign up for free ;~)

Dave
(Shameless with freebies like that ;~)
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No. of Recommendations: 3
PS. as a point of reference, how much in non-risked reserves would you advise a person keep when going naked in the securities?

I'm not the best person to ask this question of, since I don't really invest that way. I don't have a dog in that fight, so I wouldn't "advise" a person anything. My biggest advice would be to maintain an adequate level of liquidity. That's probably around $25K-$50K for most people.

But the phrase "going naked in the securities" troubles me. Going naked means something quite different than going long, but the implication here is that they are equivalent. They are not.
This has the smell of a semi-hidden agenda, that the speaker is trying to smuggle in the assertion that being long is an exaggerated risk. This is something I would more expect of a sales person (quelle surprise!) than a dispassionate seeker of knowledge.

That said ....

Risk is there, regardless of people's desire to be risk-free. At the "non-risked reserves" area there is interest rate risk, inflation risk, buying-power risk, etc. See, for example, "Cyprus, bank depositors of". Ask *them* about their non-risked reserves.

Anyway, the standard accepted ratio is 60% equities and 40% fixed-income. Right now, people who are 60/40 are going to be very sorry in the future when that 40 gets crushed down to 10. IHMO.

As for me personally, I struggle mightily to keep my fixed-income allocation up as high as 10%. I'd be happier at 5%, but that's just me -- most people feel that 10% is nuch too low. OTOH, most people couldn't walk into their boss's office at 58 and ask to be laid off.
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I'm not the best person to ask this question of, since I don't really invest that way. I don't have a dog in that fight, so I wouldn't "advise" a person anything. My biggest advice would be to maintain an adequate level of liquidity. That's probably around $25K-$50K for most people.

$25k-$50k reserves in order to put $10,000 at risk? $35k-$60k liquid net worth in order to safely put $10,000 into the S&P?

Isn't that a wee bit overly conservative? That would dramatically dilute the real yield of the $10,000 in play. (Not saying that's particularly bad... financial survival has its costs... it just seems a bit steep at its face, to me.)

But the phrase "going naked in the securities" troubles me. Going naked means something quite different than going long, but the implication here is that they are equivalent. They are not.
How specifically?

Risk is there, regardless of people's desire to be risk-free. At the "non-risked reserves" area there is interest rate risk, inflation risk, buying-power risk, etc. See, for example, "Cyprus, bank depositors of". Ask *them* about their non-risked reserves.
Of course. In our comparison we're talking about market price risk exclusively, right?

Dave
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FWIW I did my own simple spreadsheet with 0-12% cap using first of the year S&P prices back to 1950. I added 2% annually for dividends.

A single $1000 investment would be worth $280k using the S&P, $90k with the caps.

Seems to confirm the earlier results somewhat.

-murray
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$25k-$50k reserves in order to put $10,000 at risk? $35k-$60k liquid net worth in order to safely put $10,000 into the S&P?

Isn't that a wee bit overly conservative? That would dramatically dilute the real yield of the $10,000 in play. (Not saying that's particularly bad... financial survival has its costs... it just seems a bit steep at its face, to me.)


Oh. I thought you were asking the question in general. Evidently you were asking in relation to an investment portfolio.

For the general case, I was thinking along the lines of an "emergency fund". I was thinking that you need $25-50K to tide you over (paying for mortgage & groceries, etc.) for 6-12 months if you lost your job.
Although, I must say that the guy who writes http://www.controlyourcash.com makes a good case for *not* having a dedicated e-fund. "5) An emergency fund. Just kidding. No one who actually understands money has one."


But in relation to an investment portfolio .... that's a matter of asset allocation. That's probably the #3 or #4 most discussed topic at financial sites, so it's been rather throughly covered.

Frankly, I think that thinking in terms of "non-risked reserves in order to safely put $10,000 into the S&P" is embracing defeat from the get-go. If you can't afford to put $10K into the market, don't do it. I think that some Financial Advisors emphasize people's fears in order to push them into inappropriate investment vehicles.

Not quite sure what the thrust of your question was -- perhaps I've over-reacting.

dramatically dilute the real yield of the $10,000 in play.
Um .... if you only want to put $5K at risk, only invest $5K. Don't play foolish games by investing 10K and then directing 5K of it into some purportedly "non-risked reserve", and thinking that you have thereby invested 10K.

You shouldn't mentally segregate your net-worth into distinct buckets, but should think of it as all one big lump. You (you, Dave Leverage Planner) have said this yourself, when you say that you need to have the picture of a client's entire financial situation in order to advise them properly.

Really, somebody's "non-risked reserve" is their job and other solid income-stream(s). It's silly to isolate one chunk of their net worth (like in an IUL) and saying that part of it should be at risk and another part of it should be non-risk.

Market risk? Whatever. Keep it all in perspective. There's the risk that you'll be squashed by a runaway gravel truck on the drive to work. (Not being facetious. I saw this happen twice in the 18 years we lived in Algonquin.)
You are not going to lose all your money that's invested in the S&P500. If a crash happens and you lose half of it -- bummer. Hang on and it'll recover in a few years.
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You are not going to lose all your money that's invested in the S&P500. If a crash happens and you lose half of it -- bummer. Hang on and it'll recover in a few years.

OK, let's take this perspective then;
$100,000 liquid net worth.
How much of it would *you* (RayVT) put into an unhedged-long buy & hold position on the S&P, with the backward-looking wisdom & awareness of typical S&P drawdowns, versus "life happens" potentiality of needing to raid it for junior's uninsured skateboarding incident?

Do you keep just 3 months' living expenses nut aside where its free from drawdown risk? Less? More? How much?

Dave Donhoff
Leverage Planner
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How much of it would *you* (RayVT) put into an unhedged-long buy & hold position on the S&P, with the backward-looking wisdom & awareness of typical S&P drawdowns, versus "life happens" potentiality of needing to raid it for junior's uninsured skateboarding incident?

Is it just me, or is Dwdonhoff changing his argument after presented with real world returns?

Your question is unanswerable with the information given. Are we talking about a married couple? Two incomes? Job risk? Total assets?

Personally, we were nearly 100% all in stocks with maybe $50k in an e fund. In 2007, I started shifting our allocation knowing we would retire some day.

Our average return over all investments since '92 is around 7.5%.

-murray
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OK, let's take this perspective then;
$100,000 liquid net worth.
How much of it would *you* (RayVT) put into an unhedged-long buy & hold position on the S&P, with the backward-looking wisdom & awareness of typical S&P drawdowns, versus "life happens" potentiality of needing to raid it for junior's uninsured skateboarding incident?


None.
Zero.
$000,000

First of all, "incident" thing is why you have insurance (homeowner's and health). But still, a valid question if you substitute "unexpected expense" for that bit.

Oh, my! So many points to respond to. Here goes ... ;-)

1) "unhedged-long" -- Implies that there is such a thing as a hedged long position. There isn't. A "hedged long" position is effectively just a smaller position. Which by definition is unhedged, that is, an unhedged smaller position. (Which, BTW, is why covered calls are a stupid strategy -- they hedge away all but a teeny bit of the profit.) This phraseology is just fear-mongering.

2) "buy & hold" -- I don't do buy & hold. Of *anything*. Every investment strategy I use is subject to some form of a market-timing overlay/gate for shifting my equity allocation to short-term or intermediate term bonds/T-bills. It's not perfect, and it's not ultra-technical, or genius-level, or requires a massive or superhuman effort as CC likes to taunt. It just moves to cash when the general market is in a downtrend, and back to equities when in an uptrend. It takes approximately 2 minutes once a month. Maybe 4 minutes if you have to boot up your computer first.

3) "S&P" -- I don't actually invest in the S&P500. I invest in various ETFs and individual stocks. But still, saying S&P is a valid synonym for "equities".

4) "backward-looking wisdom [of S&P]" -- All anyone has to do is pull up a long-term chart on the S&P. Here's one: http://finance.yahoo.com/q/bc?s=%5EGSPC&t=my&l=on&am...
Now look for a time when you can say, "If I put money in here and didn't touch it for several decades, that would suck." Can't find one, can you? Even the peaks right before the crashes of 1974-75 & 1987-88 don't look bad when you can see the entire picture.
Due to recency bias, the crashes of 2001-03 and 2008-09 look big and bad. But then you notice that EVERY prior period had its peaks & valleys, so these ones are not different -- they are just recent.
In 20-30 years, the 2000-2010 peaks & valleys will occupy the same position that 1970-1980 does now. IOW, just spiky noise way down on the chart.

5) "& awareness of typical S&P drawdowns" -- Yup. Drawdowns happen. That's life. Sometimes you hit a golfball and it lands in the lake. Hell, I saw Tiger Woods nail one right into a pond at Cog Hill. Arrange your affairs so that a large drawdown doesn't wipe you out.
Diversify.
Personally, I diversify not only between asset classes but also between strategies.

If drawdowns *didn't* happen, then investing would be risk-free. And therefore return-free. Like a bank account or CD. No volatility and also very low return.

6) "life happens" potentiality of needing to raid it" -- So, which is better, having $250K in an account that was worth $400K 2 years earlier, or having $75K in an account that has never ever had the possibility of a losing month? You understand the low-risk of having a mortgage along with enough assets to "stroke a check" to pay it off. No difference.

The only thing is the way you look at it. I read a psychology article recently that explained this. People tend to compare the current price (or account value) with a recent price. If the price has dropped, people feel the loss (sad). If the price has gone up, people feel the gain (happy). This is so even when the reduced value is greater than the increased value. So $400K going to $250K feels BAD and $70K to $75K feels GOOD -- even though you are better off with the former.

As for me personally, I do my best to have my intellect control my emotions, so I grit my teeth and stick with the former. The object is to have lots of digits in your net worth, not to have good feelings about a low-digit balance.

The worst case here is when you have a sudden need for the money shortly after you started the account. But in that case, *neither* of these alternatives will have enough money, so you're S.O.L. in either case.

Hmm, not true. The worst case is when you started just before a crash, so it hasn't had time to grow before it gets whacked -- and then you have to take money out and eat the loss. This is called bad luck. "Sometimes you eat the b'ar, sometimes the b'ar eats you." This happens sometimes, just as getting squashed by a runaway gravel truck sometimes happens.

Do you keep just 3 months' living expenses nut aside where its free from drawdown risk? Less? More? How much?
Nope.
Yes.
No.
$0 Or did you mean "how many months"? That's 0, also.

When I was a teenager, I used to be very frugal about paying $1 for a paperback book. (Showing my age here!)
When I was making $50,000/year salary I didn't even consider it. If I saw an interesting $9.95 book I bought it without a blink.
Ponder upon that parable.

If the market crashed so bad that "living expenses" was a worry, then that would be the least of my worries. A bigger worry would be if I had enough ammunition stock.

Come to think of it, I don't ever recall a time when I purposely had N months' living expenses tucked away. The right way to think of your net worth is as just one big pool of money (assets) that's in various forms/assets & various levels of liquidity -- cash, bank accounts, stocks, bonds. Ammo. Etc.
Bucketing your money is for Dave Ramsey / Suzie Orman readers who are in the "get my butt out of the wringer" category.

Money is fungible. Stocks/bonds/etc. convert into cash with just one phone call and a $10 commission. You can even have it wired to you before end-of-day for another $25. All you need in cash or near-cash is enough to float you over cash-flow irregularities. And for the occasional handy-man who'll give you a discount for greenbacks instead of a check.

$10,000 that is free from drawdown risk is $10,000 that is not earning anything. We don't want no lazy money around here! Get to work! That money could be earning 3% in a 1-3 year bond fund, at the minimum. 6%-7% in a preferred stock or bond. So, yeah, there's a modicum of drawdown risk -- so grab a couple of its lazy buddies and stick $20,000 in that bond. Now there's $20K earning 6%-7% and I've got an even bigger cushion in case I need the cash in a downturn.
$20,000 that is temporarily cut down to $18,000 is more than $10,000 -- and we've already defined that $10,000 is the sum I need in case of emergency.

And in the highly likely case where I don't have to tap that $10,000, in 10 years that $10K will have grown to $20K. Which is, um, $10,000 more than I would have in a "free from drawdown risk" pot. Better yet, the $20K will have grown to $40K and I can take $20k out and put it to doing some *real* work earning 10%-15% in stocks.

Sorry, hope this wasn't TL;DR. But you did ask. ;-)
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Hi Murray,

Is it just me, or is Dwdonhoff changing his argument after presented with real world returns?
Its just you. I haven't changed anything.

Your question is unanswerable with the information given. Are we talking about a married couple? Two incomes? Job risk? Total assets?
Right off the bat, I stated "$100k liquid net worth."

After that, the situation is different for everyone... however I explicitly asked Ray his personal discretion were he to have that net worth.
==============

Ray,

1) "unhedged-long" -- Implies that there is such a thing as a hedged long position. There isn't.
Of course there is, and *YOU* just defined one 2 sentences earlier. If you are "long" your home, and you buy homeowners insurance, you are placing a hedge.

A "hedged long" position is effectively just a smaller position.
Not in direct proportion, no. You can go long $100,000, and hedge against loss up to 100% without selloing 100% for significantly less than $100,000.

A naked long is strictly a bet on price without time considerations. A hedge is often a bet including time considerations.

If you buy a $100,000 home, and "lose" $250 a year by hedging with hazard insurance, you are doing so because if a fire (drawdown) wipes out your equity you don't want to live in a tent in the park while you wait out the time to manually rebuild your home without external financial support. Yes, you are still "losing" your $250 a year, every year that the insurance hedge is not needed... but the year it is needed the payoff from the hedge *INCREASES* your net position, not decreases.

A hedge is only necessary for the assets you can't afford to lose, during the TIME FRAME that you cannot aford to lose them.

Bill Gates doesn't need to buy fire insurance on a $100,000 property (assuming he would ever bother owning one.) If the property scorched, he wouldn't even notice the cost to rebuild on his balance sheet.

If an investor needs $1,000,000 accumulated equity by age 65 to fund their retirment lifestyle, and they are in a market environment with historical drawdowns of 50%, they can't afford to go naked until they have at least $2MM accumulated.

Our comparison exercise is not in regards to a speculative trading account, its in regards to the OP's inquiry about retirement account management. Accounting for the expectable market behaviour within the last 5-10 years prior to drawdown is critical to the results.


I'll cover more later... have an appointment in minutes... chau!
Dave Donhoff
Leverage Planner
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Gentlemen,

I have been thoroughly enjoying the debate of IULs vs. a simple S&P index. Thank you for your contributions.

If I may, allow me to offer a small suggestion to the question about what amount of cash or "non-risked reserves" to hold. I believe a reasonable and conservative approach is to hold 5 years worth of cash or cash equivalents. In this case it would be 5 years worth of the proposed withdrawls. I believe you are calculating a withdrawl rate of $1500/month or $18,000/year. So I would suggest that the year withdrawls begin, $90,000 be taken out of the S&P index and placed in CDs. This would represent "risk free" money that could be used to avoid having to sell securities during a severe market correction.

KB
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More response on Ray's post;

2) "buy & hold" -- I don't do buy & hold. Of *anything*. Every investment strategy I use is subject to some form of a market-timing overlay/gate for shifting my equity allocation to short-term or intermediate term bonds/T-bills. It's not perfect, and it's not ultra-technical, or genius-level, or requires a massive or superhuman effort as CC likes to taunt. It just moves to cash when the general market is in a downtrend, and back to equities when in an uptrend. It takes approximately 2 minutes once a month. Maybe 4 minutes if you have to boot up your computer first.
3) "S&P" -- I don't actually invest in the S&P500. I invest in various ETFs and individual stocks. But still, saying S&P is a valid synonym for "equities".


Is this the strategy you would recommend to our OP, instead of an IUL?

If you would *not* recommend a long-term naked S&P500 strategy, and you've already admitted it doesn't match the performance of an IUL when safety is considered, why are you trying to push it as superior?

You don't seem to recommend an apple, you prefer bananas, yet you want to try to compare apples to orangutans.

Brandonisme
http://boards.fool.com/7702-private-plans-indexed-universal-...
I'm trying to find reasons why I wouldn't want to do this, but it seems like it's not really all bad.

4) "backward-looking wisdom [of S&P]" -- All anyone has to do is pull up a long-term chart on the S&P. Here's one: http://finance.yahoo.com/q/bc?s=%5EGSPC&t=my&l=on&am......
Now look for a time when you can say, "If I put money in here and didn't touch it for several decades, that would suck." Can't find one, can you?


That's irrelevant for retirement strategies, which (by definition) is money that has to be there regardless of the timing (surprise) of retirement. There are plenty of places in the historical chart you can see you might enter, and be completely S.O.L. if you subsequently had no choice but to stop contributing and begin liquidating.

5) "& awareness of typical S&P drawdowns" -- Yup. Drawdowns happen. That's life. Sometimes you hit a golfball and it lands in the lake. Hell, I saw Tiger Woods nail one right into a pond at Cog Hill. Arrange your affairs so that a large drawdown doesn't wipe you out.
Diversify.
Personally, I diversify not only between asset classes but also between strategies.

'Diversification' is just another word for hedging/covering. It reduces your direct growth potential (and often also loss potential.)

If drawdowns *didn't* happen, then investing would be risk-free. And therefore return-free. Like a bank account or CD. No volatility and also very low return.

*THIS* is the religious faithful voice... the fallacy that you cannot take market gains unless you also allow the market the opportunity to hand you losses. Its a fallacy.

A simply bull call debit spread (which is guaranteed to mature with a value between 'worthless' and 350%-ish up,) using 5% of your liquid account, financed by the safe yield from 95% of your account held in guaranteed/insured yield assets, does exactly this. A 340% gain on 5% of your account equals a 17% gain over the entire account, with zero chance of losing any of principal back to the markets.

The object is to have lots of digits in your net worth, not to have good feelings about a low-digit balance.

ABSOLUTELY AGREED!!! And the key to accumulating lots of net worth is to keep the gains, methodically.

The worst case is when you started just before a crash, so it hasn't had time to grow before it gets whacked -- and then you have to take money out and eat the loss. This is called bad luck. "Sometimes you eat the b'ar, sometimes the b'ar eats you." This happens sometimes, just as getting squashed by a runaway gravel truck sometimes happens.

ABSOLUTELY AGREED... for a full risk speculation account... not a lifestyle-guaranteeing retirement account.

$10,000 that is free from drawdown risk is $10,000 that is not earning anything. We don't want no lazy money around here! Get to work!

ABSOLUTELY AGREED... just put at risk of drawdown/loss *ONLY* the money you can actually afford to lose. Until you can afford the losses, grow it hedged (just like insuring a home you cannot yet afford to rebuild out of lunch money cash.)

=================

BY THE WAY...
I have the historical "total S&P500" data (with the shifting dividends,) back to inception now. I will get that added into the mix, and correct the missing spend-downs, sooner or later (likely later, after I am back from the tropics ;~)

Once the model is solid, we can run it for successive rolling periods to see the difference, and how much the risks cost, versus how much safety costs.

=================

Hi KB,

I believe a reasonable and conservative approach is to hold 5 years worth of cash or cash equivalents. In this case it would be 5 years worth of the proposed withdrawls. I believe you are calculating a withdrawl rate of $1500/month or $18,000/year. So I would suggest that the year withdrawls begin, $90,000 be taken out of the S&P index and placed in CDs. This would represent "risk free" money that could be used to avoid having to sell securities during a severe market correction.

An interesting approach... not sure if Ray's willing to do that (in fact, based on the above, it appears he'd be quite unwilling to do that.)

In the IUL it wouldn't be necessary, since there is no risk of a drawdown and distribution via policy loans is at a positive arbitrage to the overall account (meaning the cost to borrow against the cash value is less than the avg returns of the cash value, so withdrawing costs more than borrowing,) so it makes sense to peel out funds on an as-needed basis.

Cheers,
Dave Donhoff
Leverage Planner
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If you are "long" your home, and you buy homeowners insurance, you are placing a hedge.
Whaaat???? This makes no sense.

Wikipedia: "A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment."

Investopedia: "Definition of 'Hedge' Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract."

Homeowners insurance replaces your house if it burns down in a fire. It doesn't do anything to protect you from a decline in the value of your house.

I'm out of this particular subject. Your idea of what a hedge is is completely different from the actual definition of "investment hedge", so it's useless to discuss it.

How did a house and homeowners insurance get dragged into this thread, anyway. We are talking about investments, not homes.


If an investor needs $1,000,000 accumulated equity by age 65 to fund their retirment lifestyle, and they are in a market environment with historical drawdowns of 50%, they can't afford to go naked until they have at least $2MM accumulated.

Ha! Then they'd better invest in the right vehicle(s) so that they actually accumulate that $1M, hadn't they? You can't just invest in any random "risk-free" way and assume that it'll get you to $1M. People (especially people with a particular agenda) try to believe that you can get high returns with low risk. You can't. Low risk comes with low returns. High returns come with high(ish) risk.

Here's an real-world example. Playing with my spreadsheet, Jan-75 to Dec-2012. Initial investment of $10,000, and adding $158/mo. The S&P500, with re-invested dividends, using the simple 10moSMA timing gate, grew to $1,000,000 by May-2010.

Big drawdown occurs, and it drops to $834,000 by Oct-2010 -- a HUGE 17% drawdown.

Meanwhile, the IUL-type floored/capped strategy had a value of $420,000.

Hmmm, what to do? Which to choose?
One the one hand, $834K after a big drop. On the other hand, $420K with no drops ever.
834 -- 420 ... 420 -- 834
Hard to choose, no?
Maybe I'll call my wife in and ask her which one she thinks is better.

===========
Dave, you keep using loaded words & phraseology. You keep calling a long position "naked". No normal investors term it that way. A long is a long. The only customary use of "naked" in investment parlance is a "naked short" position. And a naked short is pretty well known to be a high-risk position.
When you use "naked" to refer to a long position, you are trying to smuggle in the idea that it is a high-risk situation.

Ditto when you try to claim that homeowners insurance is a hedge. It may (or may not) be the way insurance agents think of fire insurance, but it is definitely not the way that "hedge" is used in investment terminology.

When you misuse words this way, you lower your credibility in eyes of people who know the field. Either you know that you are misusing the words -- and therefore are being dishonest. Or you *don't* realize that you are misusing the words -- and therefore are showing ignorance.
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If I may, allow me to offer a small suggestion to the question about what amount of cash or "non-risked reserves" to hold. I believe a reasonable and conservative approach is to hold 5 years worth of cash or cash equivalents .... This would represent "risk free" money that could be used to avoid having to sell securities during a severe market

I used to think this was a reasonable idea. But I've recently read some papers & articles that changed my mind.

Don't have a link handy, but the argument goes like this:
* You want to have an asset allocation of, say, 10% cash and 90% equities (stocks, bonds, etc.)
* You do this because want to avoid having to sell stocks when they are down, so you withdraw from cash instead of selling stocks.

But:
* What you are doing when you spend the cash is shifting your asset allocation to HIGHER equity allocation levels. Instead of 10/90 it becomes 5/95.
* If the bear market lasts longer than your cash cushion, then you are 100% equities. You wanted to have no more than 90% stocks because you wanted to feel safe. But yout strategy caused you to move toward 100% stocks -- the exact opposite of your goal.
* AND, when you've used up all of the cash, you now are selling stocks even deeper in the downdraft. Instead of selling some when they were 5% down, you wind up selling when they are 20% down.

They convinced me that this "cash bucket" approach is mostly an illusion, and that it completely fails you just when you need it the most -- in a terrible downdraft.
You have the comfort of feeling safe, right up until the sawblades hit.

** Their conclusion is that it is safest to maintain your chosen asset allocation, even in a down market.
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Is this the strategy you would recommend to our OP, instead of an IUL?

I'm not in the business of recommending specific strategies to people. Anyway, he couldn't afford what I'd charge. ;-)

If you would *not* recommend a long-term
naked
You keep using that word. I do not think it means what you think it means.

... S&P500 strategy, and you've already admitted it doesn't match the performance of an IUL when safety is considered, why are you trying to push it as superior?

Um, because it *is* superior.

performance ... when safety is considered
The phrase you are looking for is "risk-adjusted return". It's a well-known concept in the field of investigating & analysing strategies. As the words imply, there are two components: 1) risk, 2) return.
It's the return considered in light of the risk. It's not all about "return", nor all about "risk", but the melding of the two. Low risk accompanied by low return is not neccessarily better than medium risk accompanied by high return.

What most people are looking for is the highest return they can get for an acceptable level of risk. And almost always, the lowest acceptable risk is higher than "no risk ever, no way, no how".

Actually, buy&hold of the S&P500 is not even in the category of outstanding strategies. But it beats buying an IUL.
Heck, a simple timing overlsy to the S&P is a large improvement over B&H. Only slighly lower returns but with much lower volatility.

The only time where an IUL is superior to simply buying the S&P is for people to whom any drawdown whatsoever is completely unacceptable, and who are oblivious to the fact that the returns are substantially less.

If you don't mind reaching retirement with $300,000 instead of $900,000, get an IUL.
To me, a $600,000 shortfall isn't worth the comfort of never having to see any intermediate drop in month-to-month value. What the hell, this is money you put away for 38 years, what's important is how much you have at 65, not all the little ups and downs along the way.

If you don't want to see a monthly statement showing a loss from the previous month, don't open the envelope. Just pass them right from the mailbox to the trashcan without opening them.
Problem solved!

You don't seem to recommend an apple, you prefer bananas, yet you want to try to compare apples to orangutans.
Apple, banana, pear, whatever. I don't have to recommend which one is the best, when all I want to say is don't eat a dog-t*rd. ANY of them is better.

fallacy .. that you cannot take market gains unless you also allow the market the opportunity to hand you losses. Its a fallacy.
You go right on thinking that.

A simply bull call debit spread (which is guaranteed to mature with a value between 'worthless' and 350%-ish up,) using 5% of your liquid account, financed by the safe yield from 95% of your account held in guaranteed/insured yield assets, does exactly this. A 340% gain on 5% of your account equals a 17% gain over the entire account, with zero chance of losing any of principal back to the markets.
And yet all those greedy Wall Street sharks, all those folks with maga-computers co-located with the NYSE computers, networked with fiber-optics because 1GHZ ethernet is too slow....all those smart guys who grok gamma and delta and theta as easily as you or I grok change for a $10 bill --- those people never realized that there is this simple technique will give them guaranteed 17% gain with zero chance of loss.

Color me sceptical.

I can't count the number of times I've read somebody's foolproof method to make money with complex option strategies. They always end in tears.

=============================
I have the historical "total S&P500" data (with the shifting dividends,) back to inception now.
Great! Is it posted somewhere for download? If not, can you put put it up somewhere?

Once the model is solid, we can run it for successive rolling periods to see the difference, and how much the risks cost, versus how much safety costs.
Sounds good.
Although, at some point -- which is rapidly approaching -- all that needs to be done is upload the spreadhseet somewhere it's publicly accessible. Then people can d/l it and plug in parameters on their own.

'course, first the spreadsheet needs to be correct and free of errors. And preferably have accurate dividend information, rather than just a fixed estimate. If you can't get that data to me, maybe I'll try to eyeball it from the chart. Rather have the numbers, though.

Thanks for catching my error on the m-m vs. y-y for the way IUL caps work. I hope that's the only error.
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Rayvt,

But:
* What you are doing when you spend the cash is shifting your asset allocation to HIGHER equity allocation levels. Instead of 10/90 it becomes 5/95.
* If the bear market lasts longer than your cash cushion, then you are 100% equities. You wanted to have no more than 90% stocks because you wanted to feel safe. But yout strategy caused you to move toward 100% stocks -- the exact opposite of your goal.
* AND, when you've used up all of the cash, you now are selling stocks even deeper in the downdraft. Instead of selling some when they were 5% down, you wind up selling when they are 20% down.


I do something similar but different. I move my cash to passbook. I maintain a 6 month minimum of expenses and have had it as full as 18 months. I do not consider it as part of our portfolio when I look at allocations, etc.

They convinced me that this "cash bucket" approach is mostly an illusion, and that it completely fails you just when you need it the most -- in a terrible downdraft.
You have the comfort of feeling safe, right up until the sawblades hit.


I refill from dividends and any position trimming that I do. I either sweep cash from brokerage to savings or hold it for reinvestment.

For near-cash, I have a larger cash holding, 21.5% of our portfolio today, in an IRA insurance annuity that earns 4.5%. I raided it a couple times for stock opportunities, replacing it with sale proceeds. It has become a smaller percentage of our portfolio over the past few years despite numerous transfers into it from brokerage.

We retired in 2005 and have not dipped into any near-cash(the IRAs) or sold anything in a market downturn to pay expenses. We actively manage our cash position since it is what we live on. The concept would fail if you don't maintain an adequate cash and near-cash position.

I look at this setup as our version of the CD/bond ladder of 5 years worth of expenses outside of the stock market.

This setup is also why I find no value in any of these IUL offerings.

Gene
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If you are "long" your home, and you buy homeowners insurance, you are placing a hedge.
Whaaat???? This makes no sense.


A Beginner's Guide To Hedging
http://www.investopedia.com/articles/basics/03/080103.asp
<SNIP>
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event.

Yep... Investopedia... that's a pretty obscure & oddball reference source ;~)

How did a house and homeowners insurance get dragged into this thread, anyway. We are talking about investments, not homes.
A retirement account is a 'financial home' equivalent. It is relied upon by most folks, usually without alternative options, for their survival.

Dave, you keep using loaded words & phraseology. You keep calling a long position "naked". No normal investors term it that way.
I guess it depends on your idea of "normal." I learned market finance from professional traders where risk management is everything, and undercapitalized drawdowns kill more accounts than anything else. Not saying that's superior, or normal... but that's the world I know.

A long is a long. The only customary use of "naked" in investment parlance is a "naked short" position. And a naked short is pretty well known to be a high-risk position.
A naked long is equally high risk to a naked short (at least down to zero.)

When you use "naked" to refer to a long position, you are trying to smuggle in the idea that it is a high-risk situation.
'Smuggle' is a loaded word & phraseology... it implies I am saying something with a meaning other than what I am actually saying. I am not. I am overtly stating that a naked position (long *OR* short) is unhedged, and at full risk of loss without time constraint.

Ditto when you try to claim that homeowners insurance is a hedge. It may (or may not) be the way insurance agents think of fire insurance, but it is definitely not the way that "hedge" is used in investment terminology.
Perhaps you can educate Investopedia... they're apparently not as wise as you in this aspect.

When you misuse words this way, you lower your credibility in eyes of people who know the field.
HAH!! That is rich!

In other news, my 3 year old toddler scolded me this morning for shaking hands with his teddy bear "the wrong direction" ;~)

Allow me to help you;
Definition of 'Naked Position'
http://www.investopedia.com/terms/n/nakedposition.asp
A securities position that is not hedged from market risk. Both the potential gain and the potential risk are greater when a position is naked instead of covered (a covered position is hedged from market risk).

Maybe you could benefit by hanging out with real financial professionals... at least in vernacular (if not returns, which I trust you are doing fine in ;~)

Color me sceptical.
Me too... except I dig deeper.

I have the historical "total S&P500" data (with the shifting dividends,) back to inception now.
Great! Is it posted somewhere for download? If not, can you put put it up somewhere?

Of course, I'll get it up as soon as I can put some focus time into that project.

Although, at some point -- which is rapidly approaching -- all that needs to be done is upload the spreadhseet somewhere it's publicly accessible. Then people can d/l it and plug in parameters on their own.
Yep, will do... that's why I shared a link for a free Dropbox account. (If anyone particularly prefers I not get credit for the free account, just get it straight from the Dropbox website.)

Thanks for catching my error on the m-m vs. y-y for the way IUL caps work. I hope that's the only error
I've only eyeballed the equity curves, not dug deeper into the data & calculations, but it doesn't appear at first blush that the spend-downs were addressed. The IUL is going to have a more gradual glidepath, potentially with more distribution even if/when the S&P account grew more on the accumulation (it definitely will in certain market periods.)

We'll get that all sorted along the way... the data is out there, & not going anywhere ;~)

Dave Donhoff
Leverage Planner
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have the historical "total S&P500" data (with the shifting dividends,) back to inception now.
Great! Is it posted somewhere for download? If not, can you put put it up somewhere?


Never mind. I got my butt in gear and managed to find the historical yields.

I've only eyeballed the equity curves, not dug deeper into the data & calculations, but it doesn't appear at first blush that the spend-downs were addressed. The IUL is going to have a more gradual glidepath,

Not sure what you mean by "spend-downs". I'm just an Arkansas hick[*], so maybe this is going right over my head -- I understand "withdrawals" and that's what I modeled. Is that another of those Inigo Montoya words?
[*] transplanted Arkansan, but still ...

Yes, the IUL did have a more gradual glidepath.
Right into oblivion. ;-(

After somebody(s) take a look at the "iul-check" the spreadsheet and verifies that the calculations are valid, and I've had a chance to correct any errors, I'll upload my spreadsheet. Alas, it's gotten rather complicated, what with all the parameters.
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Dwdonhoff:

<<<1) "unhedged-long" -- Implies that there is such a thing as a hedged long position. There isn't. >>>

"Of course there is, and *YOU* just defined one 2 sentences earlier. If you are "long" your home, and you buy homeowners insurance, you are placing a hedge."

Not in any traditional sense of the financial market.

How does that property insurance policy protect anyone from a decline in the value of the house.

There is are no equivalents to puts and calls for homes.

<<<A "hedged long" position is effectively just a smaller position.>>>

"Not in direct proportion, no. You can go long $100,000, and hedge against loss up to 100% without selloing 100% for significantly less than $100,000."

Nothin you wrote in this response contradicts Ray's prior statement.

"A naked long is strictly a bet on price without time considerations. A hedge is often a bet including time considerations."

If it often includes a time consideration, then sometimes it does not, so that is not a defining characteristic.

"If you buy a $100,000 home, and "lose" $250 a year by hedging with hazard insurance, you are doing so because if a fire (drawdown) wipes out your equity you don't want to live in a tent in the park while you wait out the time to manually rebuild your home without external financial support. Yes, you are still "losing" your $250 a year, every year that the insurance hedge is not needed... but the year it is needed the payoff from the hedge *INCREASES* your net position, not decreases."

And if you have to move across country and sell your house after the real market has turned down, how does the insurance policy hedge such risk?

I see none, unless of course you are willing to suggest arson (which I doubt).

Regards, JAFO
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Hi JAFO,

How does that property insurance policy protect anyone from a decline in the value of the house.
After a fire (absent the expense of subsequent rebuilding) your home will usually be worth less on the open market than prior to the fire.

There is are no equivalents to puts and calls for homes.
Sure there are, puts and calls can be written on any underlying asset. For individual real estate assets specific option contracts can (and are) written.

And if you have to move across country and sell your house after the real market has turned down, how does the insurance policy hedge such risk?
You're eitehr intentionally, or accidentally, reaching... to try to equate the hedge of hazard insurance to market volatility insurance.

If its easier to understand, you *could* trade specific options on the ownership of your own home with local expert real estate investors/agents. You could go long ownership of your home, and buy a put option (the discretionary right to sell it at a specific price during a limited period) to a local investor, at some mutually agreed price. You can negotiate the same with calls (long or short.) You can't "borrow a house to sell" (at least not very easily,) so short positions would have to be entirely synthetic (long put, short call,) but certainly doable.

Not typical... but the point is conceptual... and the investment account management is actual.

Dave Donhoff
Leverage Planner
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Dwdonhoff: "Hi JAFO"

Howdy.

<<<How does that property insurance policy protect anyone from a decline in the value of the house.>>>

"After a fire (absent the expense of subsequent rebuilding) your home will usually be worth less on the open market than prior to the fire."

Who said anything about a fire? You response is a nonresposnive to my question.

<<<There is are no equivalents to puts and calls for homes.>>>

"Sure there are, puts and calls can be written on any underlying asset. For individual real estate assets specific option contracts can (and are) written."

Maybe, if you are lucky, and at what price?

"Puts and calls [for securities] are generally written for one, two, three, or six months, although any period over 21 days is accepted by the New York Stock Exchange."
http://education.yahoo.com/reference/encyclopedia/entry/puts...

See also: http://www.cboe.com/ - Chicago Board Options Exchange

To what market do I go for a real estate put or call and what are the boilerplate contract terms for a real estate put or call?

I stand by my statement that there is no equivalent.

<<<And if you have to move across country and sell your house after the real market has turned down, how does the insurance policy hedge such risk?>>>

"You're eithrr intentionally, or accidentally, reaching... to try to equate the hedge of hazard insurance to market volatility insurance."

I am intentionally trying to show you why several on this board think you are misusing naked versus long and insurance versus hedging.

"If its easier to understand, you *could* trade specific options on the ownership of your own home with local expert real estate investors/agents. You could go long ownership of your home, and buy a put option (the discretionary right to sell it at a specific price during a limited period) to a local investor, at some mutually agreed price. You can negotiate the same with calls (long or short.) You can't "borrow a house to sell" (at least not very easily,) so short positions would have to be entirely synthetic (long put, short call,) but certainly doable."

Each one custom negotiated and crafted and without any standard provisions. Not nearly the same as calling your broker/using an interent interface to buy or sell a security put or call.

"Insurance is a practice by which a company provides a guarantee of compensation for specified loss, damage, illness, or death in return for payment."

Insurance is a heavily regulatated industry and not just anyone call sell insurance or form an insurance company. And I am aware of Lloyds.

"To hedge is making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract."

http://www.investopedia.com/terms/h/hedge.asp

Hedging does not require an insurance company, and is clearly talking about adverse price movements (not a casualty event).

Whichever source that you cited calling a hedge insurance was either a simile or a metaphor (I do not recall the exact wording and do not want to go back through the thread) and not a definitional equivalence.

An IUL essentially creates a collar, and the expenses of foregoing all dividends, plus the cost of insurance (mortaility cost), plus the other policy costs, plus the upside about the collar ceiling, and the benefits received are the floor and the insurance payout if the policy stays in force until death.

Insurance companies, like all companies are looking to make money, and hire some of the brightest mathematical minds to set their pricing. Other than companies buying market share or the occasional mis-pricing for new products, the insurance company always set the odds in its favor in the aggregate.

I still believe that for most people, if you need insurance, buy insurance. If you are looking for investment choices, buying an investment wrapped in insurance is rarely the best way of doing so with first dollars, which not to say that there are not some people for whom it makes sense. Unfortunately, the number for whom it makes sense is usually smaller than the number who are actually purchasing it.

Regards, JAFO
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Howdy JAFO,

Who said anything about a fire? You response is a nonresposnive to my question.
YOU said, that's who. You asked how haz insurance protects against a value decline, and I showed you how.

I understood what you meant (but did not say) was how you could insur against a drop in market value, and I then explained how to do *that* with options.

You said there were no such thing as options on real estate, and I objected (which you are now acknowledging that I was right... and are now merely objecting to the terms of options, not their existence.) You never specified 'standardized exchange-traded options' and the distinction would have been irrelevant because its not necessary for undertstanding the concept of hedging.

Of course using options to hedge values of non-commodity assets is inefficient, nobody was suggesting to actually do so. We are talking about using options to hedge retirement accounts, which are just as critical to lifestyle maintenance as the roof we sleep underneath.

Whichever source that you cited calling a hedge insurance was either a simile or a metaphor (I do not recall the exact wording and do not want to go back through the thread) and not a definitional equivalence.
We can let it speak for itself;
A Beginner's Guide To Hedging
http://www.investopedia.com/articles/basics/03/080103.asp
<SNIP>
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event.

I still believe that for most people, if you need insurance, buy insurance. If you are looking for investment choices, buying an investment wrapped in insurance is rarely the best way of doing so with first dollars, which not to say that there are not some people for whom it makes sense.

The overwhelming majority of people I talk to who want zero-floor, market growth features do not give a damn about getting any additional life insurance death benefit, and if I could structure the trade better with the same features outside of an IUL I would... but I can't at present because tax law allows the IUL companies to provide much higher safe-leg crediting from their established general accounts than new money can get in equally safe fixed yield securities.

When zero downside, market upside strategies are available that outperform what IULs provide, I'll use those instead for the people that want that.

For people who can afford to lose 25% to 50% of their account value and wait 10-20 years to catch it back up, I can do *MUCH* better than an IUL... but that's not what we are talking about.

Dave Donhoff
Leverage Planner
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I would like to acknowledge JLC, KluverBucy, and thomasbihn's courteous participation on this topic.
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