The Free Lunch Illusion: How Fear and FOMO Feed Wall Street

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Wall Street’s creativity knows no bounds, especially when it comes to selling safety or income. In this episode, Greg revisits Warren Buffett’s timeless wisdom to uncover who’s “swimming naked” in today’s market. 

Drawing on Rob Arnott and Edward McQuarrie’s recent CFA research on risk and investor psychology, he explains how both fear of loss and fear of missing out drive market behavior far more than models admit. Greg dissects several headline-grabbing products, from “high income” S&P 500 ETFs and 77% yielding Nvidia options funds to the Dual Directional Buffer ETF and the “Magnificent Seven Snowball,” revealing how they offer the illusion of safety or income while eroding long-term returns. He closes with a Buffett-style case study on Occidental Petroleum and Berkshire Hathaway’s recent deal, underscoring the power of simple, steady cash flow over engineered complexity.

As Leonardo da Vinci said, “Simplicity is the ultimate sophistication,” and it is also one of the surest ways to compound wealth.

Topics Covered

[00:00:41] – Who’s swimming naked? The illusion of risk-free returns
 [00:02:31] – Understanding risk and fear in markets: Rob Arnott’s research
 [00:06:22] – How fear of loss and FOMO distort risk premiums
 [00:09:19] – The rise of high-income ETFs: chasing yield in disguise
 [00:12:32] – The Nvidia ($NVDA) income strategy ETF: 77% yield, but at what cost?
 [00:16:09] – Dual Directional Buffer ETF: the illusion of protection
 [00:21:14] – The “Mag 7 Snowball” structured note: Wall Street’s creative packaging
 [00:25:47] – Why these structures guarantee Wall Street wins
 [00:26:45] – Buffett, Occidental ($OXY), and the value of consistent cash flow
 [00:32:20] – Simplicity, cash flow, and the sophistication of staying patient

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Disclaimer: This discussion is for educational purposes only and not investment advice.

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Transcript

[00:00:11] Greg Denewiler: 

This is Greg Denewiler, and you are listening to another episode of the Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks. When they grow over time, a funny thing happens: you create wealth.

Welcome to episode 52 of the Dividend Mailbox. Today, we're going to try to figure out who is swimming naked. 

Ever since I have been in the business, which is now a long time going all the way back to 1979, Wall Street has figured out a way to come up with new investments that give you the illusion that there are ways to make money in this market without all the risk that's out there. But this was one of the sayings that's attributed to Buffet: “You don't find out who's swimming naked until the tide goes out.” So, we're going to take a few different tacks and look at risk. One of them is going to be a great research piece that's come out in the last few months. And then, the market's been doing well—there have been multiple things that have come out, really trying to capture your attention, give you what sort of looks like a free lunch. One of them in particular, just to give a little bit away, is actually based on Nvidia. Leave it to Wall Street to come up with an idea to take something that pays virtually no dividend and generate a phenomenal income off of it. So you'll just have to listen and find out just exactly what's behind that brilliant idea. We'll look at several of them and try to keep you from getting caught swimming naked when the tide goes out.

As a CFA charter holder, I am required to do 20 hours minimum a year of continuing education. The CFA prides itself in really getting into the nuts and bolts of all this statistical relevance and how these assets are correlated or uncorrelated or risk and blah, blah, blah. Well, an article caught my attention the other day. It was by Rob Arnottt and Edward McQuarrie. The title of it was: Fear, Not Risk, Explains Asset Pricing. Rob Anott runs research affiliates. He does a lot of—it's basically a quantitative firm. He does a lot of research for the CFA Society. He's a very, very technical guy, really understands all the concepts behind modern portfolio theory, CAPM, capital asset pricing model, and the efficient market hypothesis.

These things all came out around 1960 or a little after. There were several Nobel Prizes awarded for them. They are all centered around: there is a perfect portfolio, or assets are at least somewhat efficiently priced. One of the big principles that he really goes into is that he thinks the market is not nearly as efficient as what research suggests, and he even goes on to say, everybody pretty much knows it's not, but they don't really know what to do with these formulas that markets have been based on for the last 50 years.

What Rob came up with was, you know what? We really need to go back to the drawing board because the market is really driven by fear, and it's not just fear of loss; it's also fear of missing out. He goes through all these different cases where, you know, the models just don't hold up. One of the things that happens is that the risk premium changes.

Risk premium, for those who don't know, the risk premium is the additional return over the risk-free rate that an asset will generate, and there's a debate on even really what the definition of a risk-free asset is. But we're just going to keep it simple here. A risk-free asset is a six-month treasury. The yield right now is 4% on a six-month treasury. Just a market in general, if you use the 10% long-term total return of the S&P 500, that would be a 6% risk premium. 

We're seeing this recently just in gold, as gold has really been on a tear this year. You know, we could go back to, well, what does gold do? It's really just a store of value, although about half the gold that's mined, as I understand, goes to India for jewelry, but even they are using it in some form of a store of value. It's really just the perception of what somebody else thinks gold is worth and are they willing to pay more than you? Well, this year a lot of people are willing to pay more because gold's up about 40%, so that becomes the fear of missing out. Everybody wants into gold. Now it's become the headline trade.

The flip side of that is fear of loss. When things start going down, people don't care what the company is, what they do, whether they're profitable or not, what the outlook looks like. If an asset is down 30%, it's like “We want out.” And you see that in the S&P on these big corrections. 

You know, 2008 we went down almost 55%. There was a time there when it looked like the financial system, as we know it was in real peril. You had people selling, and they didn't care at what price. You see it over and over. That's just what fear does, because when things are not going well, all these great charts that show prices just go up over time. If you hold them long enough, you're going to make money. If you have a good diversified portfolio, if you own the S&P 500, you're going to make money. In 2008, we had recovered from a 55% decline, well, less than 10 years, earnings bounced back in a time period of about four and a half to five years. So if you know that the economy is going to recover, then why would you ever be tempted to sell the S&P 500? It's because when prices are going down, you start worrying they're going to go lower. And you wanna get out, and then you wanna buy back in later, it virtually never works out well. That's really kind of the premise of what this article is about. The measurement of risk changes, and it's all driven by fear. 

And people can actually fear missing out as much or more than fearing loss, depending on the investor. These things are not equally weighted; that's where it gets complex. That's why Rob thinks that the risk premium actually changes. 

So it's worth reading if you're kind of into this kind of stuff, but it's really what leads to, I think, a lot of these other products coming out. Wall Street is really good at coming up with ideas that'll make you think you're going to be able to get some return, and you're not going to have the risk associated with it, or not nearly as much. In the end, it's patience, and you just have to be careful trying to generate things that aren't really there. So what I've seen lately, they're just more and more wideS&Pread. I'm not going to give you, the symbols or the companies for, I hope you realize obvious reasons. It's probably not going to be hard to figure out what some of them are. I'm not here to bash companies, but I am here to try to help you realize the value behind these things. 

The first one is called the S&P 500 High Income ETF. This whole podcast is about yield and a growing income stream and how to build one. What if you had the S&P 500 and instead of just earning 1.25% roughly, you got a distribution rate of 12%? You might be thinking, Hmm, okay, sounds like a winner to me. If you look at what's in this fund, it's Nvidia, Microsoft, Apple, Amazon, and Meta. That represents about 25% of the fund. That's very close to what the S&P 500 is.

The first question would be, okay, where's the free lunch here? I mean, how, how, how does this work? The way they do it it's pretty simple. This particular fund is an option writing fund. They sell calls against their positions. And I love the description on this thing, so it aims to generate high monthly income by investing in the constituents of the S&P 500 index and implementing a data-driven call option strategy. Everybody should have a data-driven call option strategy. Well, how well has that worked? Maybe not so well because if you go back to January of ‘23, the high-income ETF is up, price-wise, 15% while the S&P 500 is up 82%. Now you've had some income coming off of this high-income ETFs, and it's paying 12% right now.

But here's the problem. What do you think's going to happen when the market goes down? The price is only up 15%. It's really compounding in reverse. If the market gets hit, the price of this thing is going to get hit, and then it's going to be much harder for it to recover down the road. The total return is going to get extremely challenging.

Since its inception, the high-income ETF is up 14% annualized rate of return while the S&P is up 18.7%. I mean, you've given up four and a half percent a year in total return, but you sort of own the same thing. That's a pretty hefty give, just to get the illusion of an income stream. But as the market just continues to trade higher, people are looking for yield, so it does attract attention. 

Well, that leads us to everybody's favorite stock right now. Well, maybe not everybody, but Nvidia. All the headlines—it's the big winner. It's the center of the AI universe. Nvidia pays a dividend. It's actually in a lot of dividend growth ETFs because it's got a phenomenal growth rate, but it's not hard to double when you have a 0.005% yield and you wanna double it to 0.01%. There's basically, for intents and purposes, zero yield here. All of the return is in the price. There's nothing wrong with that; it's just what it is. Well, guess what? Wall Street came up with a brilliant strategy: The NVIDIA option income Strategy ETF. It advertises a distribution, a dividend yield of 77%.

Gee whiz, how can you go wrong? Owning the best company in the universe and then generating a 77% yield on it? It seems like a no-brainer. Uh, maybe not so much because if you go back to when this thing started back in the beginning of 2023, on just the price basis in the last two years, it's down 15%. On a total return basis, which includes the 77% income you're getting, the Nvidia option Income Strategy Ts is up 280% over that same period. Nvidia, the stock itself is up 550%. 

So you've been getting all this income out of it, but you gave up half the return of Nvidia for the illusion of a great income stream. If you want to own a great company and then just own a great company. What you're doing is you're selling off your upside each month for cash flow, and over time it's going to eventually erode your principal.

What do you think is going to happen if Nvidia actually goes down for a while? It's kind of like you're on the backside of the mountain. Once you get too far down it compounding is just not going to be strong enough to pull you back up. You have to be extremely careful with these things, and it's probably better just to stay away from them, but apparently, a lot of people haven't because there's $1.8 billion of assets in this thing right now.

So the next one that popped up, this one, I got an email. I glanced at it, and I'm like, what in the world is this? Because one of the things that these people are trying to do is to give you the perception that you can still get a return, but they're going to help keep some of the risk out of your portfolio. Which brings us to the dual-directional buffer, ETF.

They give you a few scenarios to give you an idea how this thing works. Scenario one, if the S&P 500 return is positive, the fund seeks to match those gains up to a cap of 10.6% a year. So it's like, okay, well, you get 10%. Not bad. However, we'll see how good that is here in a second. 

Scenario two. If the S&P's price return is down by 10% or less, the fund seeks to deliver a positive return of the same size. It's inverse performance. So if the market's down 5%, you're actually going to get plus 5%. Here, what they're trying to do is give you the illusion that you know they're really helping you smooth your returns out, and they're taking some of the risk away. 

Well, in scenario three, if the S&P five hundred's price return falls more than 10%, the fund will also lose value, but the first 10% is softened by the buffer. So if the S&P is down 15%, then this thing is down 5%. If the S&P is down 30%, this fund's down 20%. 

Well, here's the problem, and if you don't kind of go through the simple math, you're going to realize that A, you can get into a hole on this thing pretty fast. Even though they're trying hard to smooth the returns out, as you can see, there's really more downside than there is upside because the upside's capped at 10%. So the reality is, why would you really want this thing? Most people just don't think the market's going to go down by much. Or if it does, it won't stay down there very long. So, therefore, I'm going to go for that smoother return and figure that unless the end of the world comes, I'm in pretty good shape.

Well, in 2019, the S&P was up 31%. You got 10.6%.  In 2020, S&P was up 18%, you got 10.6%. In 2021, S&P was up 28.7%. You got 10.6%. In 2022, S&P was down 18%. You were only down 8%—you got a little bit of a positive there, but in 2023, on the bounce back, S&P was up 26%. You were up, take a guess, 10.6%. If you kind of start doing the math here, when you get these down years and you're only climbing back 10% a year, this can create a real potential problem. You get out to ‘24, the market was up 25%. This thing's up 10%. Year to date, this thing's already capped out because the market's up more than 10%. 

When things are going well, everything looks good. But if you get into some down years, you start digging a hole. It's going to get harder for this thing to climb out. You really have to be careful with the perception of getting some of the risk out. And here's the part that I think fools people: if you look historically, market returns always tend to come in groups. The average long-term return is 10%. I think we've been through this a few years ago in an episode, but even though the average market return is 10%, it's very seldom in that range of 8% to 12%. It's either better or it's worse. So personally, I think it makes these things very unattractive.

This same group, in case this one didn't appeal to you, has, guess what? 97 other ones that may fit what you're looking for: The max buffer, the deep buffer, the buffer, the dual directional buffer, the moderate buffer, the conservative buffer, the enhanced and moderate buffer, and the buffer and premium income. So you pretty much, whatever buffer you want, they have a buffer for you. All of these things are trying to appeal to either an income component, the perception of limiting loss, but you're giving something up in all of these. That's how these guys make money. On the surface, it looks like it's designed to smooth out returns and to make it look a little safer. If you do the math, it really doesn't bring anything to the table except putting more costs into your investment. There's a reason why these firms bring these things out.

So finally, this is my all-time favorite of having no idea what you're going to end up with. It's marketed as the “Mag Seven Snowball” by some genius investment firm, and I probably shouldn't say the name, but it is a really, really big name. I'll leave it at that. The concept here is: if the snow is just right, kind of moist, but not too wet and not too dry, that snowball going downhill is going to get really big, really fast.

The way it works, and I just have to read you these bullet points because it's just beyond comprehension. This thing has a three-year life, and I'll get into that here in a second. 

Scenario one is: Out of Meta, Amazon, Google, and Microsoft, you take those four stocks. If the worst performing underlier is flat or positive on the first call date of 12 months, then you receive back your principal plus 33%. What that means is if they're all up, and Amazon is only up 1%, you get 33.85% and it doesn't matter which one. Well, that sounds pretty good. 

If the worst performing underlier is flat or positive on the second call date, which is, in this case, 15 months later, you receive back your full principal plus 42%.

The next date in 18 months, you will receive 50%. Then we go out for 21 months. Same thing, flat or positive, the worst performing, you get roughly 60% and you get out 24 months, it's 67.7%. So at maturity, three years out, if the worst one is flat or positive, you get 101% back. You have to be thinking, “Wow, this sounds like a free lunch.”

Well, what if the other three are all up 200% a piece? You basically just gave away the farm, but the numbers look attractive if you don't have to worry about which one to pick or which one you hold or what percentage, or, you know, whatever. 

But we're not done yet because that maturity, which is three years from now, if the worst performing underlier is down, but not down more than 30%, then you get your full principal back. Again, what if one of them is down 30% and the rest of them are up? Then you quite likely would've had a positive return. You only get your money back. The appeal is you're not risking a whole lot, but you start to see how these guys are going to make money.

Here's the killer because there's never a free lunch In all of these companies, these things are all built where these companies can hedge and basically guarantee themselves a profit. That's how they make money. They're not there to be Santa Claus. So in this case, at maturity, if the worst performing underlier is down more than 30%, so let's just say Amazon is down 35%, then you're down one for one with the worst performing underlier. You lost 35% of your money, and it doesn't matter if the rest of them are all up. 

It looks like a sure thing because the market is so obsessed with these Mag Seven right now. It just looks like, “Okay, maybe they don't keep going straight up, but are they really going to go down?” It looks like there's just a great return built into these things, and you're protected against loss except in what somebody might argue is more of a worst case, but there's significant risk there. The structure of these things guarantees that Wall Street eventually wins at your cost. The only thing I can tell you is good luck with that one.As you can tell, I'm not a fan of these things, and I think people should just stay away from them and stick to what is simple. 

With that, what I think would be really helpful here is: what are the points to these things, or what's the point I'm driving at? Well, I think as we continue on here, on our little journey this month, simple cash flow, compounding it, nothing replaces it. It's efficient. It's much cheaper to operate, and it's a whole lot more predictable. So now we're going to go into something that popped up just recently, and I think this is a great example of this is how you build wealth. Not trying to hedge this or that, or have some buffer that I'll make money, but if things don't work out so well, I won't lose so much.

Well, this was announced, I don't know, within the last week or so. If you follow Berkshire Hathaway, you are aware that Warren Buffett started to take a position in Occidental Petroleum back in February of 2022, and started buying the stock. If you go back a few years earlier, in April of 2019, he bought— it was a special issue just to Berkshire Hathaway, a $10 billion preferred stock to help Oxy Finance an acquisition of Anadarko Petroleum. It was an 8% preferred. He still owns it. Occidental at the time, wasn't exactly the best credit quality, so you take the money you can get if you need it bad enough, and if you think your returns are going to justify it. So he entered the preferred stock position.

He started to buy the common, as I said, in 2022. Currently, he owns about 28% of the company. Interestingly enough, he's got about $10 billion in it. That's what the 28% ownership represents. On the very first purchases, he's probably up about 17%, but since March of 2022, he's negative on most of what he owns in Occidental. So he has two positions here. He's got a $10 billion preferred, which in six years has paid him out over 50% income, not counting any compounding. Then he has the common that he's holding on to. He's made multiple statements that he loves the CEO, thinks she's doing a great job, and is going to create some value in their oil and gas reserves.

What was just recently announced, part of Oxy's business is a chemical division. The CEO has decided to liquidate OxyChem, and guess who's going to buy it? Berkshire Hathaway. They're going to pay about $10 billion for it. The EBITDA on it is running around $800 million. That is a yield of about 8%, which, ironically or not is roughly the same thing that his preferred is paying. 

Here he is now, he will have three different positions, roughly each one of them is about $10 billion. He's got two-thirds of it paying him about 8%. It could be a little better when the economy's better, since the chemical division is a little cyclical.

These are the kind of businesses that he loves, and since he's going to own the entire chemical division, it'll become a subsidiary of Berkshire Hathaway. The whole thing is a dividend to him. You don't have any phenomenal growth here, but what you have is just tremendous compounding of the cash flow he is going to generate off of it.

So what I find kind of fascinating here; the CEO says that we want out of the chemical division because we think we can earn more money over in oil and gas over time. It's going to be to our shareholders' benefit to own the common is basically what she's saying. Well, here you've got a guy that has the inside track, gets to talk to the CEO, perfectly legal, he just can't trade on the information. Instead of putting another $10 billion into the common, he still chooses to take the cashflow piece of the business and let the speculation go somewhere else where it may or may not work. He has been one of the big wealth creators of all time, and lo and behold, what does he go after? He goes after the consistent cash flow. The problem with these buffers is they're not sustainable cash flow machines. They're all doing it off of some kind of derivative. You know, these funds and the NVIDIA 77% yield— well, people have a fear of missing out. They want in on it. This is a way they think they can sort of get in and not take quite as much risk.

Well, fear of missing out makes you do some things that later on you very well could regret. As Rob Arnott talks about fear of missing out—it's like, “I wanna own Oxy common and I wanna see what this lady can do, going out and finding oil, and I want the big hit. 8% a year cash flow? Too boring for me.” Well, Mr. Warren Buffet would have a whole different opinion. 

So we're going to start to wrap this up. This was kind of a little different approach this month, but we continue to always look for ideas and we're always trying to figure out how to compound cash. But if you notice all of these products that I'm going to call them, these buffers and ETFs that are packaged, what they really are appealing to is either your fear of missing out— the perception of advantages of the returns they're offering—or the fear of loss, where they give you the perception of protection, but it all comes at a cost. 

One of my favorites is from Leonardo da Vinci, and it is: “Simplicity is the ultimate sophistication.” Buffet is an expert on keeping things simple. It changes your focus a little bit and takes it away from price, focuses it in on cash flow. When you compound that over time, great things can happen.

If you enjoyed today's podcast, please leave us a review and subscribe if you would like more information regarding dividend growth or our investment strategy, please visit growmydollar.com. There you will find previous episodes and also our monthly newsletter. If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com.

Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks including dividend stocks are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.