Does Your Investing Approach Match Your Investor Type?

Knowing what type of investor you are is one of the key principals of being a successful investor.  An investor cannot make reasonable plans (and has an even harder time sticking to those plans) if he doesn't know what he's trying to achieve.  Handling the ebbs and flows of the market become less emotional once an investor has decided what his growth goals are and what type of risk he can accept and still sleep at night.  To oversimplify this point in an effort to keep this idea limited to one article, consider three broad types of an investor:

1. Buy and hold - Take what the market gives and hope for the best.  This investor believes that stocks are likely to go higher over time and doesn't worry about each dip.  Dips in prices might be seen as more of a buying opportunity than a trigger to worry.  Either way it doesn't matter because this investor buys consistently each and every month in the same dollar amounts, no matter what the market conditions.
2. Reduce potential risk and reduce reward - Accept a little risk, but not enough to try to beat the markets.  This investor is easily spooked and while he agrees stocks will likely move higher over time, the fear of losing money is not worth the potential gain.  He would rather wait for a dip to stop falling before making any new purchases, even if it means missing the bottom.  Purchases are inconsistent and are often poorly timed due to fear.
3. Increase risk and increase potential reward - A more aggressive approach that could lead to more volatility in an account.  The third investor doesn't mind risk because she knows the market will be higher eventually.  Every dip is seen as a buying opportunity and she will likely increase investment amounts for each level lower in the market indexes.   Purchases are inconsistent and can lead to increased losses when fundamentals are ignored, but can also lead to much better returns when the markets go her way.

1. Buy and hold SPY.  Investor One could buy a basic S&P 500 index ETF.  SPY is an ETF that attempts to mimic the returns of the S&P 500.  SPY's expense ratio (fees) is negligible at 0.09% which helps it stay close to the index's annual returns.  The investor receives dividends (currently a 1.99% yield) while holding SPY.  The historic return is between 10-11% annually, including dividends.
• Downside Risk: Unlimited, for every 1% the S&P 500 losses, so does SPY.  The investor will incur a loss immediately, with the first tick lower in SPY.
• Upside Potential: Unlimited, for every 1% the S&P 500 gains, so does SPY.  The investor will make a profit immediately, with the first tick higher in SPY
2. Sell SPY put options.  Using the same ETF, investor Two could sell one put option on SPY with a $131 strike for a January expiration (25.6 weeks from the time I took these quotes).
• Downside Risk:  The downside risk is also unlimited, but does not start right away.  If the investor sold the put option when SPY was trading at $131.73 and received $7.30 per contract, losses do not begin until SPY has fallen 6.09%.  The option investment loses money at the same rate as the index after the initial 6.09% drop.  This cushion softens all market corrections (and nullifies smaller ones) and helps the worried investor sleep better at night.  For example, the investor could exit the position without losing a penny if the index fell 6.0% (or less) by the time the contract expired.  If the index was down 10% he would only be down 3.91% on his investment.
• Upside Potential: All of the potential profit is received by the investor up front when an option is sold.  This caps the potential profit at 5.9% for this single contract or 12.0% annualized, slightly better than the S&P 500 average return.  SPY can even lose 0.5% and the investor will still take the full 5.9% profit in less than six months.  If SPY gains 25.0%, the investors still only gains 5.9%.
3. Sell SSO put options.  Investor Three could use an "Ultra ETF" that also tracks the S&P 500, SSO.  The difference over SPY is that SSO attempts to mimic double the daily return of the index.  This additional risk creates additional opportunities too.  Investor Three could sell one put option on SSO with a $52 strike for a January expiration (25.6 weeks from the time I took these quotes).
• Downside Risk:  The downside risk is also unlimited, but does not start right away.  If the investor sold the put option when SSO was trading at $52.58 and received $5.50 per contract, losses do not begin until SSO has fallen 11.55% or roughly 5.75% for the S&P 500.  This cushion softens small corrections, but due to SSO's double exposure positioning losses increase beyond the S&P 500's losses once the index corrects more than 11.55%.  For example, the investor could exit the position and break even if the index fell 5.75% by the time the contract expired, but if the index was down 11.55% she would also be down 11.55% on her investment.  For every 1% drop in the index beyond this mark the investor losses 2%.  In a major market correction these losses can be substantial.
• Upside Potential: All of the potential profit is received by the investor up front when an option is sold.  This caps the potential profit at 11.8% for this single contract or 24.0% annualized, more than double the S&P 500 average return.  SSO can even lose 1% and the investor will still take a full profit.  No matter how high SSO climbs, the maximum gain is 11.8% in less than six months.