Balanced Approach With Loss Avoidance
Mark Triplett | February 27, 2018
For nearly three decades interest rates have declined. Stock market volatility sent investors fleeing to safety, driving interest rates further south. Americans saving for retirement have been forced to make a choice between historically low interest-rates succumbing to eroding effects of inflation, or risking their money investing in a volatile and unpredictable stock market.
Recent market crashes have caused many sleepless nights and undo stress, worry and anxiety for many Americans near or in retirement. Perhaps you know someone who retired only to have to go back to work following market corrections. Maybe that person was you.
We believe in a balanced planning approach that makes use of a loss avoidance strategy.
Average vs Real Return
It starts with understanding the difference between average rates of return and real rates of return.
Let’s say you start with $100,000 to invest. You invest it all in the market. The market goes up 25%. That’s reasonable, wouldn’t you say? It’s happened before. In that case your $100,000 becomes $125,000.
As we all know, the market goes up, and it also goes down. We don’t know when it will go up, and we don’t know when it will go down, or how much.
Historically, the market goes up over time more than it goes down. So for this example we’ll say the market only drops 20%. Therefore it went up 25%, and has now dropped by 20%. We started with $100,000 which became $125,000, but how much do we have now?
The value of the investment drops to $100,000. Why is this? Mathematically, with regard to percentages, losses damage values more than gains advance them.
We started with $100,000, and we ended with $100,000. That’s a 0% real rate of return over two years. At least we didn’t lose anything, right?
The average rate of return is a different story. The market went up 25%, then went down 20%, for a net gain of 5%. Divide it by two years, and we’ve earned an average rate of return of 2.5%.
So we have a 0% real rate of return, and a 2.5% average rate of return.
The pundits on financial networks, and commission brokers love to beat their chests about average rates of return over a period of time. However, we deal with real rates of return because our real clients need real money to spend in retirement. Average rates of return don’t put fuel in the tank or food in the body.
We believe in applying a loss avoidance strategy. Avoiding losses sounds great, and it is, but there’s a trade off. Accepting no risk of loss during a bearish market means you won’t get all of the potential gain from during a bullish market.
Assume for a moment that we only get to keep half, or 50%, of the positive market index movement during year. In exchange, we’ll experience no market index related losses at all during a down year.
As with our previous example, we start with $100,000. This time when the market goes up by 25%, we don’t receive all of it. We only get to keep 50% of it, or 12.5%. Our $100,000 has now become $112,500, not $125,000.
The following year the market drops by 20%. Applying a loss avoidance strategy, we will lose 0% in a down year. How much do we have now? We still have $112,500. The average rate of return for the period is exactly the same as it was before. 25%-20% = 5%. Divided by two, it equals 2.5% average rate of return.
What about the real money? What about the real rate of return? We began with $100,000, and now we have $112,500. That’s $12,500 more than what we started with. Divide $12,500 by $100,000, and it equals 12.5%. Divide 12.5% by two, and it equals 6.25% per year. That’s real money that real people can spend to buy real things in retirement.
You see, there are three entities fighting over your retirement dollars. Each one aggressively competes for your money.
The banks will tell you why you should put your money with them. They offer interest, liquidity, and safety. They’re FDIC insured after all.
The insurance companies will tell you why you should put your money with them. They’ve been around keeping promises to policyholders for 100 years or more, and they are the only financial institutions that can guarantee an income stream for as long as you live backed by the full faith and credit of the company.
Then you have Wall Street firms telling you that you should put your money with them. If you want to get a decent average rate of return, you’re going to have to take some risk of losses.
We believe that a balanced approach means giving some of your money to all three of them. The proper dosage depends on your specific financial goals, objectives, retirement risks, and time horizon.
The bank should get some money. Dollars that you need to spend in the next 24 months for example. You need access to it, and since you’re going to spend it soon, earning interest is lesser of a concern.
The insurance companies should get some of your money. They’re eminently qualified at mitigating risk, and are the forebears of the loss avoidance strategy we just discussed. Money that you don’t need to spend immediately, but will need to spend some time in the next 5 to 10 years might be appropriate.
Wall Street can have some. Money that you don’t need for at least 10 years or more may be appropriate for exposing to short-term risk in return for long-term potential rewards.
Imagine an unbalanced strategy. What if we had $100,000 and we gave it all to Wall Street. If the market drops 20%, you lose $20,000. Your $100,000 is now $80,000. In order to get back to even, you’ll need to earn 25%.
Now imagine a balanced loss avoidance strategy. We give 10% to the bank, 60% to the loss avoidance strategy at the insurance company, and 30% to Wall Street. When the market drops 20% you don’t lose any money in the bank or the loss avoidance strategy at the insurance company. What about the money in Wall Street? You will lose 20%. On the 30% we gave to Wall Street, you lose $6,000. That’s equal to 6% on your entire $100,000. Instead of experiencing 20% loss, you absorb a 6% loss.
When the market rebounds, the money in the bank would be unaffected. The money in the loss avoidance strategy would earn some interest based on the market movement, and your investment and Wall Street would earn a return.
It would take a 25% return to break even on your Wall Street loss. If the loss avoidance strategy receives half, or 50% of the market movement, you’d earn 12.5%, or $7,500 in the same year your Wall Street investment breaks even.
We believe a well-balanced approach, giving a little of your money to each of the interested financial institutions who are fighting over, it makes sense. Schedule a Discovery visit to begin the process of determining what the proper dosage is for you.