Volatility Is the Price of Seeking Big Returns

Dan Caplinger  August 18, 2020


How to "Invest" in the Stock Market Without Any Risk

The insurance industry has always taken a slightly different approach to working with investors, in large part because its business model requires it. Insurance companies typically accentuate the risks involved in investing and offer products that are designed to eliminate or reduce those risks. For instance, life insurance policies reduce the risk that your family won't have enough money if something happens to you, while immediate annuities ensure that you'll get a stream of regular monthly income that will never run out no matter how long you live.

You can also buy financial products from insurers that are designed to reduce the risk of losing money from stock market crashes while still participating in some of the upside of stocks. Equity indexed annuities are insurance contracts that offer you a return that's linked to a chosen stock market benchmark, such as the S&P 500 index. However, these indexed annuities have a great feature: If the stock market goes down in a particular year, the value of the annuity doesn't drop — it stays the same. 

At first, that sounds like getting the best of both worlds. You get to participate in the stock market on the upside, but when things go badly, the insurance company will protect you.

However, there's a price you'll pay to eliminate downside volatility. In fact, there are several:

  • Most equity indexed annuities set a maximum amount that they can grow during a particular time period. These caps reduce the annuity's return when the stock market is doing extremely well. So, for example, if an indexed annuity has a cap of 10% per year, then if the S&P goes up 30% — as it did in 2019 — you'll get at most a 10% rise in value.
  • Some equity indexed annuities also only give you partial participation in the stock market's gains, regardless of how small. For example, an equity indexed annuity might have a participation rate of 90%, in which case when the stock market rises 10% in a given year, you'll only get 9% — assuming no cap applies to reduce the return further.
  • Equity indexed annuities often come with significant costs, and those fees can be charged directly against your gains. So, an insurance company could charge an asset-based fee of 2 percentage points that could bring what would otherwise be a 10% return down to 8%. 
  • You can also choose optional features for your equity indexed annuity in many cases. These can be useful, but they come with extra fees as well that can eat into your return.
  • If you need your money before a set period, then you'll usually owe sizable surrender charges. A 9% surrender charge is typical for the first year you own an indexed annuity, and it slowly moves lower as more time goes by.
  • Finally, most equity indexed annuities only refer to the return of the index itself without making allowances for the dividends that the stocks in that index pay. 

That may seem like a price worth paying if it takes away the pain of stock market crashes. However, history shows that the true cost is much higher than most people can afford to pay.

Cutting a 243% Gain to Just 41%

The financial crisis was one of the toughest market environments that many of today's investors have gone through. Yet the decade that followed brought one of the strongest bull markets ever. Participating fully in that bull market was a key component of success for the best investors during the period. Even if all you did was invest in the S&P 500 index, you would've earned an average total return in excess of 13% per year between the end of 2008 and the end of 2018. That works out to a total compound return of 243%.

Using a typical equity indexed annuity to invest during that period, however, wiped out most of the gains you would've enjoyed. An illustration from Fidelity used an indexed annuity with a monthly return cap of 1.5% and found that the average earnings for the annuity would've been just over 3.5% per year, even when you include a bonus that the insurance company offered. That's because eliminating downside volatility also eliminated those months when the market soared. All in all, that annuity provided a total return of just 41% over the 10-year period.

There Are Two Sides to Volatility

There's no question that giving up the downside risk of the stock market is valuable. But if you give up too much of the upside in exchange, then you leave yourself with no practical way to reach your financial goals. That's too big a price to pay. Instead, do what you can to get comfortable with volatility, knowing that the huge gains over time will make up for the inevitable downturns along the way. It's not always easy, but the journey's worth it in the long run.

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