Today we’re talking about what happens when it all falls apart. DISCLAIMER: We’re not offering any sort of individualized investment advice. This is for entertainment purposes. We just sell life insurance.
For most financial advisors, there are a lot of discussions about retirement/financial plans, portfolios, adequacy, and strategy, but there’s not a lot of talk about risk. And what does get discussed is somewhat underwhelming.
We’ve had to fill out forms with potential clients, an RPQ (risk profile questionnaire, though every firm calls them something different) that would ask the same 7-10 questions to rate scenarios on a scale of one to five. They said things like… “if the market fell 20%, how worried would you be and what would you do?” These sorts of questions are incredibly hard for people to answer, most have a hard time quantifying that sort of thing practically.
And then we would ask them questions like, “How much money do you make? How comfortable are you with mutual funds?” After that, we would calculate a point value and come up with a score that put you either one point above or below a certain threshold.
And based on that score, it told the advisor the asset allocation the client should have. It was never about anything more than telling clients, “You should own 60% stocks and 40% bonds.”
But we’ve always felt very underwhelmed by the risk analysis that’s done because it always seems to be that the investment industry would like to pretend that the risks that we all face from a financial point-of-view can only be solved by the tools that it sells. To even discuss anything that can’t be addressed by those tools is a dereliction of your duty. And if that happens, too bad.
We realize now it was probably a CYA component for compliance. There’s not a lot of proof that the RPQ is a great tool to help clients.
The traditional way to deal with risk—as it relates to losing money because of a market downturn—has been asset allocation. That has always been the industry’s answer to solving the riddle…
How do you minimize the drawdowns when the market inevitably takes a dive?
Answer: You don’t buy all stocks. And you’re all set. You don’t have to worry about it. You’ve now diversified your risk.
Listening to other advisors around me, I’d hear them market themselves as “investment geniuses,” and of course the proof was in the impressive gains their client portfolios were experiencing or that money manager they picked. Never heard anyone bragging about how they planned to play defense when the market inevitably regresses to the mean.
And here’s the other interesting tidbit. When I talked to a few people about investments, they regularly wanted to know “how are gonna protect my money from a market crash?”
Giving the answer that basically says, “well, I’m gonna sprinkle your money around in all these different kinds of stock and bond funds” feels incomplete and inadequate.
People do worry about this. And a lot of people who are in the investment sales business spend almost no time thinking about it or discussing it.
What’s the most common answer from an investment advisor concerning the event when the market goes down?
“When the market drops, give it some time, and it will come back.”
“Well, you can’t time the market.”
“It’s about the long-term.”
These are the answers you’re going to get. They’re the ones we hear and read most often. If you search on the web, you’re likely to find about a billion people who say the same thing.
One of the considerations that never comes up when looking over risk analysis questions is the stability of employment or income. And that boggles the mind.
There are plenty of people out there whose income is profoundly influenced by what is going on with the overall economy. It’s either because they work on a commission or sales type basis or because a substantial part of their income is based on bonuses, and if times are bad, those two things don’t look so good.
But the investment industry spends very little time talking to them about what risks they face if there is a market correction or a slowdown in the economy that means they don’t get their bonus. All this discussion would slow down the process of them buying a product, and that’s inconvenient at best.
So much of what we see out there masquerading as financial advice takes a sort of “holier than thou” posture. The common belief is, “you should live below your means…if a percentage of your income is variable, you should learn to not commit yourself to things that go beyond your baseline income.”
That’s great. But there’s no such thing as stable income for most people who are working. Perhaps some thinking and strategic planning should take this into consideration as well when evaluating risk. It turns out market risk does increase the need to diversify, but that means so much more than the investment industry cares to explore.
This problem is not fixed by telling someone, “you should have x-amount in stocks and x-number in bonds, leave a little in cash, and you’ll be fine.”
You must look at the overall pieces and parts of the financial picture. If 95% of your liquid net worth is in your 401k, which is 60/40 bonds, you might not have lost as much as in 2008. That was a sort of diversification risk mitigation.
The point is that didn’t help you too much if you lost your job. Minimizing your losses—and maximizing your overall rate of return—doesn’t mean anything to the mortgage company.
You can’t call them up and go, “well I can’t pay this month, but my advisor told me my portfolio is going to come back.”
All those strategies that people talk about are just investment strategies. All it addresses is your investment portfolio, and that may be an excellent philosophy to use for your investment portfolio, but don’t confuse your investment strategy with your financial planning strategy.
The investment strategy is but one small component of your total plan. The investment companies have done a great job of persuading everyone that picking the right investments equals having all your bases covered.
And that’s not the case.
We have noted for a long, long time now that life insurance brings to the table a lot of nifty features that help address a lot of these considerations. Life insurance is an excellent complement to your other assets: IRA, 401k, non-qualified brokerage account, real estate, exotic car collection, gold bullion, etc.
Not only does it have a risk profile that allows it to not decline when the market drops, but it affords lots of opportunities and breathing room that other investment tools are not going to give you.
Case in point: When markets crash and economies slow down, unemployment rises. One of the worst circumstances that can befall people is losing their job and not having enough money in an emergency fund to pay the bills. In that circumstance, the 401k balance becomes the emergency fund.
When you look at the 401k in that sense, all distributions are counted as income, and you pay taxes on that income, and because it’s a qualified account, you’re going to pay a penalty tax on it too (if you’re under 59 ½). Now, the ivory tower financial advisor would wag a finger and say you’re not supposed to use it that way. But when it comes down to not buying groceries or paying the penalty, you’re going to pay the penalty and the taxes every time.
There are ways that you can build assets that more perfectly accommodate those circumstances. If you had a 401k and life insurance as part of your portfolio, and you’re unemployed, you can go to life insurance and use that to pay cover any shortfall. There’s no tax implication.
If taken as a loan, you don’t even lose the money that you’re compounding inside the policy. And once things recover and you’re back on firm footing, you can put the money back.
Consider this, if you have to raid an IRA to pay the bills, you can theoretically pay it back, $5,000 a year, but you can’t put it all back at once. You’ve lost all the growth and possibly missed out on the market recovery.
What happens if you don’t get dinged up by the bad economic storm and market crash? You keep your job and don’t experience any dip in your income.
Great news, you now have a not-so-great position in the stocks you own, but lots of cash that was unaffected in the life insurance policy. So, time to go bargain shopping. You could take money out of your policy and buy investments that are at a deep, deep discount.
And guess what, you can broaden your thinking too…what if you’d pulled money from your life insurance policy to buy real estate on the coast of Florida in 2010 or in SoCal during the same time frame? I’m pretty sure you’d be happy today.
You should always think about buying assets at a discount with money that’s in your life insurance policy, whether that be stocks, real estate, or a business. People are counting down the days to retirement who accelerate those days when the economy goes south. For the business owners, when that comes up, they’re not going to get the figure they were thinking, but they’re going to get something.
If you have a 401k with ample cash and a life insurance policy with sufficient cash: which would you choose to tap for that opportunity?
There’s a load of additional risks that unfold with 401k loans. But life insurance: relatively few by comparison.
So, it’s important to understand that hedging risk is not just about buying a long-short position ETF. You can employ that strategy, and it will help minimize losses in a market correction, but there are more losses that you could be facing. It doesn’t even have to be a catastrophic market correction.
Asset allocation in your investment portfolio does not mean that you’ve covered yourself from having exposure to market downturns. Just because the market goes down and you own bonds, does not mean that you’re not going to lose money. Asset allocation is a way to minimize losses in a market decline, but it’s not a way to mitigate the other dangers that you face. And it’s not a way to maximize opportunity.
So, if you’re not having that conversation, you should be.
Brantley is a practicing life insurance agent and has been for over 18 years. After years of trying to sell like his sales managers wanted him to, he discovered that people want to buy life insurance if you actually explain the benefits.