How to avoid another market downturn: 3 ways to handle investment risk
Monday, October 14, 2013
For the purposes of this article, we are going to review how market risk can affect your investments and potential ways to mitigate the risk. However, the true value of your portfolio is determined by more than just its raw return or value at any one time. Inflation, taxes and the time value of money are important considerations when evaluating the real return on any investment.
Before discussing how to deal with market risk, we must first define it. For the purposes of this article, we define market risk and investment risk as the potential risk to the value of your investments decreasing due to a systemic overall stock market decline. This is not the risk of a particular fund, sector or even security losing value — but rather an entire market decline.
When it comes to this type of systemic market risk, the three potential ways to handle it are:
- avoid it;
- manage it; and
- transfer it.
Avoiding Market Risk
The first way to avoid market risk is to simply stay out of the game and keep your potential investment capital in cash or cash equivalents such as money markets or CDs. The benefit of this approach is that you avoid market downturns. Clients who held a significant amount of their investment capital in cash in 2008 avoided the tremendous loss of value brought about by the down-market.
Obviously, the problem with avoiding market risk by using cash is that you also forego the opportunity for upside appreciation or even decent interest payments. In fact, since the downturn, interest rates have been close to zero for checking accounts, short-term CDs and other cash equivalents. When one also factors in inflation, you can quickly see that such market-avoidance asset classes actually provide a negative "real return."
In other words, the purchasing power of the funds in cash actually goes down over time — as low interest rates cannot keep pace with inflation. Thus, while you are avoiding market downturns, you pay a significant price — by forfeiting all of your upside potential and losing value to inflation over time. Investors who stayed in cash the last few years after being scared off the market by 2008 have missed out on much, or perhaps all, of the ride back up.
Managing Market Risk
The second way to deal with market risk is to manage your portfolio through it — either on your own or with professional money managers/investment advisors. Either way, the goal is the same — to achieve maximum return, given a targeted level of accepted risk.
Typically, both individual investors and seasoned professionals try to reduce risk through the time-honored practice of proper diversification and asset allocation. This process of investing in diversified portfolios is done every day for tens of millions of Americans and by much of the investment community.
While managing risk is common, it is not a perfect science. Many investors learned painfully in 2008 that common approaches to diversification are not foolproof. What were considered at the time "market hedges" like hedge funds, real estate and other asset classes, actually lost significant value along with the market. Many investors learned this lesson and have since paid greater attention to more significant diversification going forward by utilizing alternative asset classes to a greater extent to further diversify and manage their investment risk.
Transferring Market Risk
The final way to deal with market risk is to transfer the risk to another party. Unfortunately, this method of dealing with market risk is underutilized by most investors. The principles of transferring risk are more complex than avoidance and managing market risk.
Essentially, there are two common insurance products that transfer investment risk to third parties: 1) cash-value life insurance and 2) annuities.
With both of these product classes, you can transfer the risk of a market downturn to the insurance carrier and still participate if the market increases in value. We will drill down a bit into the life insurance product by reviewing "equity indexed life insurance."
What is Equity Indexed Life Insurance?
- A life insurance policy is a contract between a policyholder and an insurer, where in exchange for payment from the policyholder (premium), the insurer promises to pay a beneficiary designated by the insured a sum of money (benefit) upon the death of the insured person.
- Cash-value is the value of the policy contract itself — i.e. the policyholder may make withdrawals of past premiums paid and take out loans against the total value of the death benefit.
- A universal life insurance policy combines permanent life insurance coverage and flexibility in premium payments (both lump sums and regular payments) with the potential for growth of cash values by means of permitting the premiums and cash value to function as an investment tool.
A unique feature of an indexed universal life policy is that it offers protection from market risk by way of a minimum guaranteed interest rate, or "floor" rate, usually, between 0-2 percent. There will also be a corresponding "cap," or maximum amount of interest credited to the policy during positive markets, generally ranging between 10-15 percent. The movement of value of the policy is dictated by a market index, like the DOW or S&P.
With this type of product, one can have market upside to the cap (i.e., 13 percent) but have protection against market downside by the floor (i.e., 0 percent). In this way, one has transferred the market risk of the downside to the insurance company issuing the policy and yet still have upside participation. For this reason, many investors have begun to use this type of product within the diversified portfolio of asset classes.
These policies are not for everyone. The policies are best utilized in long-term plans due to the policies being illiquid. Also, specialized indexed cash value life products are not out-of-the-box policies with standard-level death benefits. Rather, these policies are heavily customized predicated on the investor's intentions. The key is choosing the right policy, tailoring it to the investor's needs and being sure to work only with top insurance companies with the highest level of financial ratings.
Investors of all types are looking to build their wealth while reducing exposure to downside investment and market risk. This article lays out three basic strategies often employed to mitigate market risk. For specific tactics within these larger strategies, we encourage you to work with advisors who understand how best to employ these concepts in a manner that fits with your risk tolerance.
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