Monday, November 28, 2011

Think Twice About an Indexed Annuity

We all enjoy playing a game we can’t lose, but investing in the stock market is not one of them. However, the promise of “guaranteed returns” led shell-shocked investors to pour nearly $30 billion into index annuities in 2009, even as they pulled $9 billion out of U.S. stock funds.

Index annuities are a close cousin of a traditional deferred fixed annuity, an investment vehicle in which an insurance company invests your money in bonds during an "accumulation period" of seven years and then converts your account into a steady stream of guaranteed income payments. An index annuity has the additional twist of tying those guaranteed payments to the performance of a stock market index, such as the S&P 500.

Guarantees are tempting in the wake of the Great Recession and continued market turbulence, but dangers lurk in the indexed annuity’s structure and fine print. In my view, the top three stumbling blocks are:
  • High commissions, up to 9 percent in some cases, that can tempt the selling agents to act against your best interests.
  • Steep surrender fees, as high as 20 percent, that can be imposed if you cash out before 10 years.
  • Product complexity that makes it tough to know what you are buying.
Beyond those concerns, according to William Reichenstein, an investment management professor at Baylor University, over the long term a very conservative portfolio easily beats an index annuity. Why do indexed annuities almost always underperform? The issuing insurance company caps your return and can adjust the cap each year. A common cap for an annuity tied to the S&P 500 is 4.5 percent. And, according to the research firm Advantage Compendium, for the five years ended in September, the average index annuity paid an annualized 3.89 percent, just slightly better than the 3.81% you would have earned in a five-year CD and less than the 5.1 percent from taxable bond funds.

Finally, please be aware that fixed annuities are often marketed at “informational lunches” that are really over aggressive, high pressure sales pitches. Remember, the old adage “There is no such thing as a free lunch” applies to the market as well.

Monday, November 21, 2011

In Praise of Rebalancing

If buying low and selling high is the secret to investing success, should you buy every time the market drops significantly? Jason Zweig argues convincingly in a Wall Street Journal article that investing during the market’s equivalent of retails’ Black Friday is not a simple path to increased returns. Sure, buying low helps, but how low does the market have to go before you buy? Also, you have to correctly identify how high is high enough to sell.

Zweig correctly identifies rebalancing—selling one asset that has gone up in price to buy another that has gone down—as the key to improving returns over time. Rebalancing works as your portfolio’s GPS. That is, you set your course with your initial asset allocation, but when you encounter roadblocks or the unexpected along your route, the GPS re-calculates your driving directions, or rebalances, to keep you on course to reach your destination.

Zweig quotes research from Francis Kinniry Jr., an investment-strategy analyst at Vanguard Group, that found that, over the past decade, regular rebalancing between stocks and bonds would have added about 0.3 percent in average annual return to a strategy of buying on dips of 2 percent or more. Further, he shares the finding that an investor with 40 percent in U.S. stocks, 20 percent in international stocks and 40 percent in U.S. bonds who rebalanced at year end over the last decade would have earned 5.6 percent annually —versus 4.9 percent for someone who merely bought and held.

Here’s another analogy to underscore the value of rebalancing. It feels great to buy a new car far below the sticker price, but you need to regularly maintain your vehicle for it to serve you well over the long-term. Rebalancing is required maintenance for your portfolio. As I look back on the technology bubble that burst, 9/11 and the financial crisis/Great Recession, our disciplined rebalancing is one of the major reasons our clients have had a better investment experience.

Monday, November 14, 2011

Don't Let Fear Thwart Your Investment Strategies

With Paranormal Activity 3 setting records at the box office, it’s a good time to talk about how fear can impede sound investment decisions. Certainly, the acute market volatility we’ve experienced over the last few years has sparked a growing fear among investors of incurring additional losses. How does this attitude impact your portfolio? Interestingly, a Fidelity survey of participants in workplace retirement plans during the turbulent 18-month period from October 2008 to March 2010 quantifies just how much letting yourself fall into fear’s grips can hurt.

Fidelity found retirement investors who kept contributing to their plan and who maintained some exposure to equities throughout the period were better off throughout the market’s roller coaster ride than those who moved in and out of the market in an attempt to avoid losses. Specifically, the 81,400 who sold all stocks in 2008 had an average return of -6.8 percent over the period. On the other hand, the 7,332,000 who sat tight and kept investing in equities earned an average 21.8 percent over the 18 months.

We tend to retreat during market turbulence because, as behavioral finance pioneers Daniel Kahneman and Amos Tversky have shown, human beings have a stronger preference for avoiding losses than for registering gains.

Recognizing and adjusting for this innate bias may help prevent you from making fear-driven decisions during dark days in the market. Think about your own behavior during past downturns. Did you make any fearful decisions that you now regret? With volatility looking like it’s here to stay, has your risk tolerance changed? If so, it may be necessary to make adjustments to your portfolio. Otherwise, the best advice to keep short-term volatility from prompting emotional fear-based decisions that can negatively impact your portfolio is to stay focused on your long-term goals.

As Benjamin Graham, a pioneer in security analysis said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” As our clients' trusted advisor, it’s our job to help minimize the impact of inescapable emotional swings and maintain disciplined investing.

Monday, November 7, 2011

Stick with Stocks

Many investors believe step one in dialing down their portfolio’s risk should be reducing equity exposure. Yes, stocks are riskier than bonds, but that’s an oversimplification that can result in some misguided moves. First, stocks provide a greater return than bonds over the long term According to Standard & Poor’s, the S&P 500 Index has had an average annual return of 9.9 percent annually from 1926 to 2010. Over the past 50 years, it’s returned 9.8 percent, and over the past 25 years, the return has been 9.9 percent. According to Ibbotson Associates, long-term government bonds have averaged 5.5 percent, 7.1 percent, and 8.9 percent during these same three time periods.

Stocks are also a better hedge against inflation. On an inflation-adjusted basis, the S&P 500 Index has provided average annual returns of 6.7 percent from 1926 to 2010, 5.4 percent over the past 50 years, and 6.9 percent over the past 25 years. There were a total of 10 rolling-year periods when the S&P 500 Index did not keep up with inflation. While long-term government bonds provided inflation-adjusted returns of 2.4 percent, 2.9 percent, and 5.9 percent over those same three periods, there were 33 rolling-year periods when long-term government bonds did not keep up with inflation. One factor influencing the gap between stocks and bonds is that, even in difficult markets, companies can increase their prices to remain competitive.

If you want another reason to invest in equities, consider this prediction by Professor Sylla, a financial historian at New York University's Stern School of Business who has studied market behavior all the way back to 1790. A recent Wall Street Journal article--A Long-Term Case for Stocks--reported his view that if the market sticks to its long-term pattern, the Dow Jones Industrial Average could climb to 20250 by the end of 2020, up 84% from its recent 10992. Additionally, he says the Standard & Poor's 500-stock index might hit 2300, up 99% from its recent close of 1154.23.

Using 10-year averages of annual market returns, including dividends and adjusting for inflation, Prof. Sylla found when 10-year-average annual returns drop below 5% as they did in 2008 and 2009, markets tend to transition to recovery.

Of course, we all know that past results cannot be used to guarantee future returns…

The real lesson in this research is that investors are best served when they take a long-term view of the market and think in terms of decades and years, not quarters.