Reinvigorate Your Financial Life With Laser Focus on Market Risk and Shortfall Risk
The financial world is noisy and it’s easy to become distracted from your most important long-term goals.
One way to cut through the noise is to focus on just the two factors that ultimately determine your approach to everything else in your financial life; namely, Market Risk and Shortfall Risk. Market Risk is the inherent risk of investing in the market; Shortfall Risk is the risk of failing to accomplish your goals.
We routinely see clients who suffer the effects of “market stress”. In many respects, this is self-imposed worry resulting from a misunderstanding of how capital markets function. Since financial literacy is largely untaught, this lack of understanding is not surprising. Part of our role, of course, is to help clients remain goals focused instead of market focused.
However, since we are all emotional beings, we sometimes see clients react emotionally to market changes. This can set us up the proverbial “horns of a dilemma”, between these two very distinctive types of risk. Without a willingness to accept some level of Market Risk the larger and potentially more problematic Shortfall Risk come into play.
Stay on Course
The dilemma presents itself very clearly. If you cannot accept the normal price changes in the markets, then you likely will find yourself decreasing one type of risk (market risk) and exchanging this for the other type of risk (shortfall risk).
The average intra-year price decline in the S&P 500 is over 14% for the calendar years dating back to 1980. In about 75% of those years, the S&P 500 had a positive year overall. You have to be able to stay on plan (in the market), in order to reap the benefits (the returns). The stress comes from believing that this tradeoff can be avoided; it can’t.
There absolutely are individuals who for various reasons can’t fully reconcile this dilemma. This point should not be downplayed...if you can’t accept the risk, don’t invest in the stock market. You will likely need to adjust your lifestyle and future plans, but that is a financial planning choice.
What's an Investor to Do When History Doesn't Repeat Itself?
We’re in an era of extremes. It seems a day doesn’t go by without the word “historical” popping up in the financial news.
The equities market and consumer debt are at historical highs. Interest rates and high-yield credit spreads are at historical lows. We haven’t seen even a 5% pull-back in the market this year—for the first time since 1995—and the DJIA is exhibiting its narrowest trading range in history. These are indeed historical times. And whether this fact has you filled with extreme optimism or extreme pessimism, you have some important decisions to make going forward.
There are theories about how we landed in this particular era of extremes, and most are rooted in the significant changes that have impacted both how we live and how we invest. At the top of the list are globalization, automation, and the largest aging population in history (yet another “historical” to add to the list). It’s said that the most dangerous words in investing are, “it’s different this time,” yet one has to wonder if, in fact, it really is different this time. Not just because of the historical market highs. After all, there always has been and always will be a new market high waiting around the corner. What’s different today is the sheer number and confluence of these extreme highs and lows—and their duration. It’s a situation no investor has experienced before, which can make these waters feel pretty daunting. History repeats itself, and investment strategies are largely built on that conviction. But what do we do when it doesn’t? When history fails to repeat itself, how can investors plan for tomorrow with confidence that they are positioned to protect their assets and gain a reasonable level of yield?
The first step is to recognize that, at least in many ways, the investment landscape really is different this time around. All you have to do is look at the numbers to be sure of that fact. And the catalysts I mentioned before—globalization, automation, and the aging population—aren’t going anywhere. If anything, the impact of each will only grow as time moves on. What that means is that there’s no way to predict what’s coming next. The only thing we know for certain is that predictability is a thing of the past (if it ever really existed at all). The result: you need to approach your portfolio differently than you ever have before.
Your goal, of course, is to find return given a risk tolerance. Current yield is an important part of total return and getting it is an elusive proposition in today’s market. If, like many people, you’re less than confident that the four major sectors that currently drive the equities market—healthcare, discretionary, tech, and financial—are poised to continue to rise at even close to recent rates, it may be wise to seek out alternatives to help drive yield without adding more risk to the equation.
But if alternatives are the wise path forward, which alternatives are the best options?
Real Estate Investment Trusts (REITs), Business Development Companies (BDCs), and energy stocks, traditionally the favored “non-correlated alternatives,” defied expectations when the stock market crashed in 2008, inconveniently revealing high correlations just as the equities market began its freefall. Anyone who was invested in these alternatives at the time knows all too well the devastating impact “non-correlated investments” can have on a portfolio, especially when they fail to do their job when it matters most.
Luckily, there is one alternative that can be counted on to remain uncorrelated to the traditional financial markets and, ultimately, deliver that precious yield: life insurance-based investments. And because this asset is literally built on one of the irreversible catalysts of change, the aging Baby Boomer population, owning life insurance may in fact be the ideal alternative to help investors generate non-correlated returns, regardless of where the market turns next. Even better, these investments typically deliver those returns with very low volatility.
What makes life insurance different is that, unlike typical alternative vehicles, secondary life insurance returns aren’t based on the economy. Instead, they are inherently non-correlated because returns are based solely on the longevity of the individual insureds.
As much as we would all love for the bull market to continue on its merry way, one thing history does tell us even today is that a bear market will come. It’s only a matter of when. As you strive to hedge your portfolios and prepare for the inevitable, life insurance-based investments are one tool that can help you achieve the three things you need most: diversification, low volatility, and yield.
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