Market neutrality à la diversification is a subject that often baffles the average financial or investment consultant. My sneaking suspicion has been that this is a result of training focused specifically on fixing a problem with a finite basket of tools at your typical investment salesman’s disposal coupled with most people’s tendency to consider good enough is good enough.
The Financial Industry Regulatory Authority (FINRA) claims there are about 11 different types of risk that an investor faces, and when you box in the conversation to simply the type of risk that your goods for sale may be subject to that’s an accurate statement. But unfortunately life is about much more than just the potential pitfalls that a stock or bond might face, and about all of the nasty gotcha’s that exist elsewhere.
How Life Insurance Complements your Portfolio
Before we discuss specifically how life insurance can complement your portfolio, we have to first address the point I made already, that risk is about more than just the potential for stock or bond depreciation. It includes things like, getting sick, losing your job, being sued, having your house burn down, the list the goes on and on. Any number of these problems can result in huge financial losses. And imagine what’s it would have been like for a retiree with a typical stock and bond portfolio to discover on January 1st 2009 that he or she was just diagnosed with colon cancer.
Now back to life insurance.
We know that fixed (i.e. whole life and fixed or indexed universal life insurance) has a strongly protected downside. The market can crash as hard as it wants and those current cash values aren’t going down they’ll even begin to rise at their guaranteed rates at the very very least.
This nifty little peace of mind comes with the understanding that when the market takes off like a good night at the craps table you’re life insurance policy isn’t going to enjoy the ride. This of course, is where the anti-life insurance crowd focuses almost all of its attention.
Is Neutral really the Right way to put it?
I’m actually ho-hum about referring to life insurance as market neutral. In large part because a number of mutual funds have attempted to manufacture funds that tag themselves as neutral and they accomplish through an array of long and short positions in stocks and various funds in an attempt to protect one’s downside.
By general design this means these funds will perform rather mediocre most of the time, but when the market contracts, the short positions will help augment return to typically make the funds perform better than they normally would, and when the market contracts a lot (think 2008) these funds look like superstars (e.g. +6% for the market neutral fund vs. -40% for the entire index).
Life insurance on the other hand tends to perform pretty well (if designed correctly) regardless. In other words, market boom or bust the product is pretty much independent of that. There are some aspects of indexed universal life insurance that make it more market correlated, but we’ve discussed before that there are other aspects that make this coveted from a strategic point of view.
Now, I’m not going to pretend like life insurers have some secret elixir that makes them immune to macro-economic trends—I assure you they are not. There are fluctuations that take place that can decrease or increase the yield on a life insurance contract. But the thing we can’t forget is that insurance companies are engaged in business that tends to yield a decent amount of revenue, and those revenues can help augment annual yield on your cash surrender value.
Diversify for Life
Diversification needs a much broader application when it comes to personal finance. Unfortunately, we’ve allowed the investment industry to hijack the term and pretend like it only applies to market investing, which is not true. There are many other risks associated with life, and money is the key driver of any lifestyle or simply continued existence. So, it’s crucial that we think of risk and diversification to avoid or mitigate this risk in much more macro terms. Cash value life insurance not only diversifies financial portfolios and protects against losses sustained from market contractions, it also provide numerous benefits in protecting against risks that life throws at us.