In the following article, we will discuss how a negative return on investment can demolish your financial portfolio. We will also give examples of life insurance products that can offer you a consistent return on investment as well as provide peace of mind knowing your family would be taken care of if you died today.
The Pitfall of a Negative Return on Investment (ROI) and How to Avoid It
[Please be aware that when you put money into an indexed account in an indexed life insurance policy you are not investing directly in the stock market. Rather, your money is being put into an account that buys options on the market. Your return on investment is based on a formula that tracks the gains (or losses) of that particular index.]
If you haven’t given your investments or your retirement serious thought, you might be one of the many people that considers a negative return just something that you have to deal with if you want to play the game of investing. Like many people you might believe that there will be positive years in the market and there will be negative years, but the average over the long run will be positive.
I remember the first time I sat down with a money manager. He warned me about the risks of investing in the stock market, but then showed me a chart that showed the Dow Jones Industrial average for the past 100 years or so. The laminated chart had a figure circled – 11% avg. annual return. I left his office thinking one thing – put money in and just wait for it to grow, the old “buy and hope” technique. Unfortunately that didn’t happen the way I planned. I had down years, as expected, but my down years were bad—real bad.
Which of the following two scenarios would you prefer?
Scenario A – You invest $1000. Your first year your investment has a return of 50%. The following year your investment has a negative return of 50%.
Scenario B – You invest $1000. Your first year your investment has a 0% return. The following year your investment has another 0% return.
Which do you think would be better? Let’s do the math and find out. A 50% positive return for scenario A would result in $1500 after year one. The following year however, the negative return of -50% hits hard. The investment would be worth $750 after the second year. Ouch!
Scenario B is pretty easy to figure out. No positive or negative returns, so the amount you put in, is the amount you still have: $1000. But that’s 25% more than scenario A! Even though scenario B had zero return, the result of not taking any losses means that the investment principle is safe.
Keep this in mind when you are looking at investment possibilities. The negative return can erase many years of positive gains. I used large percentages to make my point, but the result is similar with lower numbers. If you were an investor in 2008, you had seen year after year of positive returns, some well over 20%. And yet in that one year, you saw your investments (those exposed to stock market risk) drop by over 50%.
But it’s all back now! I’m looking good in 2017!
It’s true that the market has rebounded, and any losses you incurred in 2008 are likely back with some gains added in. However, you may have spent the last 10 years trying to get back to where you were in early 2008. Which means that you have essentially had a 0% return on your investments for 10 years. If only you could have just erased that one year.
Hopefully it’s obvious by now, that one bad year can really spoil the whole bunch.
But how do you eliminate the bad years?
Eliminating negative returns can be done a couple of ways.
First, you can invest in fixed return investments. Annuities, Whole Life, Universal Life, or even CD’s. However, most investments that offer a guaranteed fixed rate of return are going to be under 3%, which barely covers the rate of inflation.
But certain guaranteed fixed investments can still offer a level of protection for your portfolio and retirement that gives you peace of mind as you sleep at night. For that reason I mention it here and think that it can be very helpful for the right investor.[It should be noted that properly designed dividend paying whole life insurance can generate some pretty good returns (ranging from 4.5 to 5.5% over the long-term), particularly when you factor in what a similar gain would need to be in a financial vehicle that is not tax advantaged.]
The second way to eliminate negative returns is to invest in Indexed Universal Life. IUL policies typically offer a guaranteed minimum rate of return that is near 3% in the fixed account and 0-1% in the indexed accounts. This may not seem like much, but just remember that the whole goal is to remove the negative return years.
Conserving that principle balance from year to year is a strong strategy to financial wealth (and your personal health). These policies typically have a cap on the maximum rate of return that is around 12% or 13%. Which means that if the market has a banner year of 20%, you would only get the max of 13% as outlined in your policy.
But it also means that a negative year of 40% is going to result in a guaranteed return of 0-3% on your money.
Let’s take a look at two more scenarios to see this in action. But this time let’s see how a guaranteed minimum rate would impact the outcome of a market that is up and down for many years in a row.
On the left side of the chart we have a scenario in which an individual is exposed to all market ups and downs. If the market returns 50%, the investment does great, if it dips 50%, not so much.
On the right side of the chart is a typical Indexed Universal Life insurance policy. The policy has a cap of 13% and has a minimum of 1%. Each investor invests $10,000 at the start. At the end of year one the value is the same for both. However, as the negative years keep coming for the regular investor, the investor in the IUL is still locking away gains. At the end of 10 years, the Indexed Universal Life policy’s cash value is almost double that of the other portfolio.
It is highly unlikely that this exact thing is going to happen if you invest in a mutual fund. In reality there may be many more up years than down years (as has been the case in the past). However, when you expose yourself to negative returns, you need to be aware that one bad year can wipe out many years of growth.[Imagine trying to retire the year the market crashes. Better buckle down and continue working, because a stock market crash the year you plan on retiring will certainly destroy your retirement plan.]
The benefit of fixed rates of return investments, is that you know what you’re going to get. And the benefit of Indexed Universal Life is that you know that you’ll never lose money, and yet you still have a possibility of taking part in large gains.
And if you want to see this principle in action with real indexes and real rate of returns, just go grab any listing of a major stock index over the past 30 or 40 years and plug in some numbers. Pick a start date and end date and invest some money and see what happens. For one example take all the positive and all the negative returns. For the other example, cap the max at 13% and the minimum at 1%. See which scenario comes out ahead.
Who might benefit from Indexed Universal Life
The following people might find that Indexed Universal Life is the best option:
- Clients who are using life insurance for estate planning
- Clients considering business succession planning
- such as using life insurance to fund a buy sell agreement, or
- key man life insurance
- Clients who wants permanent life insurance
As always, if you’re thinking about how your investments can best serve your future needs, you should seriously consider talking to a professional that can answer the questions that don’t easily come from the internet. Your situation is unique to you and your family, so find out how your financial needs can be met today. Give us a call and we’ll help build the future you desire.