Point-to-Point

Point-to-point is a method for calculating the interest or gain on an investment over a set period. Think of it like a road trip: the only thing that matters is your starting point and your final destination. All the thrilling scenic routes, frustrating traffic jams, and unexpected detours you took along the way are completely ignored. This method simply looks at the value of an asset on Day 1 and compares it to the value on the last day of the term (e.g., one year later). It's most commonly found in insurance products like `Fixed Indexed Annuities` (sometimes called `Equity-Indexed Annuities`). In these products, the interest you earn is linked to the performance of a market `index`, like the `S&P 500`. However, instead of tracking the index daily, the insurance company just compares the index level on the start date of your contract term to the level on the end date to determine your potential earnings.

Let’s stick with our road trip analogy. Imagine you're investing in an `annuity` that uses a one-year point-to-point method, tied to the S&P 500.

• Start of Trip (January 1st): The S&P 500 index is at 4,000 points. This is your starting point.
• The Journey (The Year): Over the next twelve months, the market goes on a wild ride. It might surge to 4,500 in June, dip to 3,900 in September, and rally again in November. None of this volatility matters for your calculation.
• End of Trip (December 31st): The S&P 500 index closes the year at 4,400 points. This is your destination.

The calculation is straightforward: the index went from 4,000 to 4,400. The percentage change is: (4,400 - 4,000) / 4,000 = 0.10, or a 10% gain. This 10% figure is the basis for the interest credited to your annuity. But, and this is a big but, you rarely get to keep the whole thing.

Insurance companies aren't charities. To offer you protection from market downturns (a key feature of these products), they need to limit their own risk and your potential upside. They do this using one of three main tools. Your contract will specify which one applies.

A `participation rate` is the percentage of the index's gain you actually get. If your annuity has an 80% participation rate and the index gains 10%, you don’t get 10%. Instead, your interest credit is 10% x 80% = 8%. You “participate” in only 80% of the market's good fortune.

A `cap rate` is a ceiling on your earnings. If your annuity has a 7% cap, that’s the absolute maximum interest you can earn, no matter how high the index soars. If the index gained 10% (or even 30%!), you would still only get 7%. If the index gained 5%, you would get the full 5% because it's below the cap.

A `spread` is a percentage that gets subtracted directly from the index's gain. If the index gained 10% and your contract has a 2% spread, your credited interest would be 10% - 2% = 8%. Think of it as the house's cut, taken right off the top.

So, is a point-to-point strategy a friend or foe to the value investor? It’s complicated, and caution is the watchword.

• The Pro: Principal Protection

The biggest appeal is safety. If the S&P 500 had finished the year down 10%, your loss would typically be zero. You wouldn't gain any interest, but your initial `principal` would be safe. This aligns with `Warren Buffett`'s famous Rule No. 1: “Never lose money.” For extremely risk-averse investors or those nearing retirement, this downside protection can be very appealing.

• The Cons: Hidden Costs and Missed Opportunities

1. Limited Upside: The caps, spreads, and participation rates are a massive drag on your long-term `return`. A value investor seeks to buy great businesses at fair prices to capture their full growth potential, not a capped and limited version of it.
2. No Dividends, No Compounding Magic: Indexed annuities track a price index, not a total return index. This means you miss out entirely on `dividends`. Dividends are a critical engine of wealth, and by forgoing them, you are kneecapping the power of `compounding`.
3. Complexity and Fees: These products are often wrapped in complex contracts with long `vesting periods` and hefty `surrender charges` if you need your money early. This violates a core value investing tenet: only invest in what you truly understand.
4. Opportunity Cost: The “safety” comes at a steep price. Over decades, the stock market's volatility has been the price of admission for superior returns. By choosing these protected products, you are often trading the potential for significant long-term wealth for short-term peace of mind. A true value investor would rather own a piece of a wonderful business directly and ride out the storms.