Downside protection is one of the financial industry’s favourite sales pitches. Why wouldn’t you want to buy a financial product that stops you from losing money? The fact is that a fear of losing money in the short-term is not a logical one, and over the long-term, downside protection ends up costing you.

Investors tend to evaluate their portfolios frequently, and have greater sensitivity to losses than gains. This causes them to irrationally behave as if their time horizon is much shorter than it actually is. An obvious path to safety would seem to be hiring a person or a company that knows how to protect your downside, and the investment industry has answered this calling with sales pitches like “provides downside protection through the use of option strategies and tactical changes to the amount of its equity exposure…”, and “focuses on delivering consistent strong performance while providing downside protection”.

These sales pitches may give confidence to the emotional investor, but downside protection strategies inevitably add significant costs to the portfolio.

In this episode of Common Sense Investing, I am going to explain why downside protection is one of the least useful promises that a financial product can make.

Accepting the potential for losses is an important part of investing – risk and return are related.

If you don’t take any risk, you should expect very low returns. Financial markets tend to go up and down a lot in the short-term, but over long periods of time they have tended to go up. If you have a long time horizon, the short-term movements of the market are just noise. Over 15-year periods, which isn’t even that long in the context of financial markets, stocks have outperformed a risk-free investment over 90% of the time.

Lets reflect on that; an emotional investor might be willing to accept additional costs in order to avoid short-term declines in their portfolio, even if they have a long-term goal. Over long periods of time, the short-term declines in portfolio value are just noise, and markets tend to increase in value given a long enough period of time. Many portfolio managers will have you believe that it makes sense for long-term investors to accept lower returns in order to avoid being witness to short-term, meaningless losses.

The purest expression of downside protection is in principal protected notes. These investment vehicles are sold by banks and brokerages, and are governed by complex contracts that are not regulated or reviewed by any securities commission. The contract usually offers investors the opportunity to participate in the performance of an underlying group of assets over a set period of time, while being guaranteed to receive their initial investment back at the maturity date.

The pitch sounds pretty good to an emotional investor: they can participate in the potential upside of some assets, without any of the downside.

Remember, volatility is part of investing. Risk and return are always related. Removing risk from an investment vehicle inevitably reduces its expected return. Being shielded from the downside seems like a great benefit, but PPNs tend to have maturities longer than five years, and throughout market history there have been very few periods longer than 5 years with significant negative returns.

To illustrate this, I looked at a data set of 5-year principal protected notes issued by a Canadian bank with maturity dates between March 2006 and January 2015. Keep in mind that this data set spans the 2008 financial crisis, a time when downside protection may have seemed particularly valuable. Compared to a simple balanced portfolio of index funds, 86% of the principal protected notes underperformed over their 5-year life span. The average return of the principal protected notes was 1.62%, compared to 4.05% for the balanced index fund portfolio.

Based on the data, It seems obvious that any rational investor would select a balanced portfolio of index funds over an investment that promises downside protection, but there is more to the story. In 71% of the 5-year periods, the balanced portfolio was down more than 20% in one year, in 94% of the periods, the balanced portfolio was down more than 10% in one year, and in 100% of the 5-year periods, the balanced portfolio had a negative return in at least one year. It is by enduring that volatility in the short-term that rational investors can achieve higher expected returns.

Financial institutions understand that investors are emotional and irrational, and have created products to profit from them. Long-term investors are better off minimizing their costs, capturing the returns of the global markets using low-cost index funds, and controlling their level of risk through their mix between stocks and bonds.