What Is Defined Outcome Investing?
Defined Outcome Investing sounds too good to be true. Where else would you see “defined outcome” and “investing” in the same sentence?...
Defined Outcome Investing sounds too good to be true. Where else would you see “defined outcome” and “investing” in the same sentence? This style of option investing does indeed exist and is more accessible to everyday investors than ever before.
Historically reserved for high net worth individuals, now there are more and more defined outcome investing products on the market for retail investors like you. If you want less risk and defined return on your investment in the market, keep reading.
How Does Defined Outcome Investing Work?
First, let’s define some terms that are relevant to the apparatus of defined outcome investing:
Reference asset - Each defined outcome investment is linked to the performance of a reference asset e.g. SPY (S&P 500 Index) or QQQ (NASDAQ-100).
Reference price - This is the price of the reference asset or market index.
Outcome period - A defined outcome investment is not infinite. It is an option contract with a set time period. The time period can vary.
Buffer - The buffer is the amount of reference-security decline in which the investment does not participate. In other words, this is the amount of safety blanket you have for your investment against the market.
Example: If the market index reference asset falls by 18%, but your defined outcome investment has a buffer of 15%, then you will only lose 3% overall. The buffer has absorbed most of the decline. Some popular buffers are set to 9%, 15%, or 30%.
Upside cap - The upside cap is the maximum amount of reference asset gain over the full income period in which your investment can participate. In exchange for a buffer, you are capping your upside.
Example: Say that the reference asset soars by 13% but your upside cap is 10%. The defined outcome investment will only participate in the first 10% of the reference asset’s increase, so you miss out on 3% of the gain.
When you combine these concepts into a defined outcome investment strategy, you can create security for your investment, even during market volatility.
The contract of the defined outcome investment is set for the outcome period. You can withdraw early but your defined outcome investment will not be realized.
What Are the Benefits of Defined Outcome Investing?
There are many key features of defined outcome investing that make it an attractive option to any investor:
- Customizable risk-return profiles
With defined outcome investing, you can personalize your risk-return profile to align with your long-term strategy. You can be conservative or aggressive. Your buffer can be set to absorb downside volatility while keeping your cap high enough to help you reach your financial goals. Or you can elect to have no buffer in order to accelerate the upside, subject to a cap.
- Income Generation
With interest rates near zero, investors are vying for income. You can define certain outcomes to provide a fixed return that is superior to bonds and CDs while taking a reasonable level of risk.
How Can You Participate in Defined Outcome Investing?
Historically, defined outcome investments are sold in the forms of structured notes and annuities. More recently, issuers have offered similar products in the forms of unit investment trusts and exchange-traded funds.
What Are the Best Strategies for Defined Outcome Investments?
There are three main strategies that defined outcome investing allows you to leverage:
- best for nervous investors who want to avoid losses at all costs -
The preservation strategy is all about preventing the downside. This strategy involves replacing the “buffer” with a “maximum loss” value. The drawback to this strategy is that the upside cap will be lower than with other strategies.
Example: If you set a maximum loss of 10%, no matter what the potential negative return would be on the reference asset, you will still retain 90% of your capital.
- best for optimistic investors who want a larger return -
The growth strategy does the opposite of the prevention strategy. There is no downside protection and the buffer is typically little to none.
Example: High upside cap of 40% but 0% buffer means that your investment is vulnerable to negative returns.
- best for medium risk, medium reward investors with long term goals -
This is the meeting of the two strategies and is the most popular for defined outcome investing. You set an upside cap and a buffer that keeps your investment within certain parameters.
Example: Upside cap of 10% and 15% buffer. If the upside of the reference asset is higher than 10%, you will only return 10%. If the negative return on the reference asset is higher than 15%, you will only lose the negative return -15%.
Overall, defined outcome investing is a brilliant way to grow your wealth for long-term goals with lower risk.