Originally published on Kiplinger.com.

A relatively new financial tool can help solve the investment risk-reward puzzle by providing a buffer on potential investing losses before they occur: buffer ETFs.

The concept of risk and reward not only shapes investment portfolios, it shapes how we make choices in the world. Think back to your school years. We all did the cost-benefit analysis on when and how much to study before midterms and finals. The cost of studying is that it can be boring, difficult or just not that fun. But the reward is earning that A. The next question in your cost-benefit analysis is about the minimum amount of time you’ll need to study to get that A. So, it boils down to this simple question: How much can, or should, you risk for the desired reward?

That’s not an easy question, but consider this: if you got an A on your last test in the class, would you be inclined to study more or less? What about if you got a C? The assumption you might make is that if you got an A on your last test, then you’d have a feeling that you might not need to study as hard for the next one, given your past performance indicates a solid understanding of the material. And vice versa for if you got a C.

These days, after so much market turmoil, people tend to sit on their cash, getting cold feet when it comes to investing. Furthermore, after such a long period of upside growth, a downturn can feel like a slap in the face. Even if you understand the reward of investing, the taste of market decline is still in your mouth, causing hesitation when it comes to getting back into the investing pool.

But your investment plan shouldn’t rely on how you feel. It should be a comprehensive strategy that has a defined plan for both downturns and upswings so that feelings and recency bias can stay out of such a critical piece of your financial security.

Understanding Risk-Reward Methodology

During periods of increased market volatility and economic uncertainty, it’s important to remember your risk tolerance and develop a risk-reward analysis methodology that doesn’t rely on your temporal feelings about the market.

Risk and reward are inherently linked, and of course, investors must engage in a risk-reward analysis before making an investment decision. And while finding the risks and rewards of an investment may seem easy, doing it right isn’t a walk in the park. Before deciding on an investment, you need to think about the criteria you will base that decision on.

All investments experience some degree of volatility, and it can be tempting to make emotional decisions when your desired outcome doesn’t occur. However, by employing preset criteria for how to manage your investments, you can make informed decisions based on your long-term goals and risk tolerance, rather than short-term market fluctuations or emotional thinking.

Following investment criteria in your risk-reward analysis is essential to making informed investment decisions, managing your investments effectively, staying disciplined during market volatility and managing your overall financial risk. But that’s easier said than done.

The Risk-Reward Conundrum

Think back to that school-day analogy. If you’re trying to set a floor for the grades you want to get, you can devise a studying plan that requires you to study a set amount of time on each subject each day based on how long it takes you to read, take notes or do practice problems to understand a concept. This way, although you may over-study and it could cost you some leisure time, you can be almost certain that if you stick to that plan, you’ll get at least the minimum grade you want to get.

But in the investment world, what equivalent strategies are there? Sure, you can diversify your portfolio and opt for investments deemed more “secure.” But remember, any potential investment can see declines no matter its past performance. Look at the 2022 bond market, for example — many deemed bonds as “low risk” and even a hedge against a falling stock market. But in reality, bond prices fell in tandem with stocks.

In short, investing in your future intelligently is more complex than studying for finals. In addition, setting performance criteria is virtually impossible just by investing in stocks. However, that doesn’t mean you don’t have options. That’s where buffer ETFs come in.

Buffer ETFs: A Risk-Reward Optimizer

Buffer ETFs, also known as defined-outcome ETFs or target outcome ETFs, are a type of exchange-traded fund (ETF) that aims to provide investors with exposure to a particular market while limiting downside risk. These ETFs use a complex strategy to create a buffer against losses within a certain range, which allows investors to stay invested in the market with a lever of control over the potential for catastrophic losses.

Buffer ETFs set a specific “buffer zone” by utilizing financial derivatives so that the ETF can absorb losses without impacting the investor. For example, if an ETF has a buffer zone of 10%, then the ETF can absorb losses of up to 10% without the investor losing money. However, beyond that point, the ETF will start to lose value in line with the market. If you’re using buffer ETFs, you’re protected from losses to a certain point but also have the potential for positive gains up to a predetermined cap, making this a strategy to help manage risk.

Buffer ETFs typically have a set date at which they reset, and they are designed to provide a specific level of protection over a defined time period, which is its tradeoff for providing that buffer. For example, a buffer ETF might be designed to provide a 10% buffer over the course of a year, with a predetermined end date at the end of that period. When that period approaches, the ETF will reset, and a new buffer level will be set based on current market conditions.

Normally, an investor in the financial markets must recognize that their investment is exposed to both up and down market volatility. So, buffer ETFs are for investors who want exposure to the market but are concerned or uneasy about the lack of control they have over the performance of their investment. And in practice, they can help to reduce portfolio volatility and provide a level of protection against market downturns, which can be particularly useful during periods of market uncertainty.

However, just like setting minimum study time doesn’t guarantee you an A, it’s important to note that buffer ETFs are not a guarantee against losses, and they do come with some tradeoffs, including expenses and reduced potential for returns in some market conditions.

The Takeaway

Risk and reward are foundational concepts that we all encounter in our lives, whether it’s investing time in studying for a test or investing money for retirement. However, performing a risk-reward analysis unbiasedly is more difficult than you’d think. When markets go up, your risk-reward analysis at the moment might be different than after a downturn.

Therefore, the risk-reward criteria you set for your investments can make all the difference between thriving or stumbling through varying market conditions. A buffer ETF allows investors the ability to set investment performance criteria no matter the market condition so that they don’t find themselves shifting their investments based on their emotions toward changing market conditions.

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