It is a common misconception that two portfolios with equal average annual returns will produce equal results over time. In fact, a portfolio with lower volatility will create more wealth over time than a more volatile portfolio with exactly the same average return.
The authors of The Investment Answer illustrate the average annual return conundrum with the following parable: “It’s like the children’s story of the tortoise and the hare. ETFs to Reduce Downside Volatility The hare races like crazy but is out of control, and ultimately the tortoise wins the race. The impact of volatility on returns becomes more pronounced over time and with a greater difference in standard deviation. Remember that a portfolio that is down 50% requires a 100% appreciation just to get back to even. On the other hand, a portfolio that is down only 8% requires a recovery of just 8.7% to make up that loss. This is because the greater the loss, the smaller the base upon which your earnings can compound.”
A single $10,000 contribution will grow over ten years to $25,940, assuming 10% growth every year. An identical $10,000 contribution will grow to only $17,623 over ten years, assuming 10% average annual return but with growth fluctuating between -20% and 40% in a volatile market.
For parents saving for college or baby boomers saving for retirement, the need for money certain at a time certain and market volatility can be a toxic combination. In the wake of the financial meltdown, baby boomers and their progeny are struggling with double digit portfolio losses and a finite period to make up the difference. The choices are stark. Either pursue an aggressive growth strategy (and hope for the best) increasing principal at risk or “go conservative” and forgo potential gains to preserve principal.
This has led many sophisticated investors to seek annuities, structured products and equity-linked insurance products for the prospect of above market returns and lower volatility.
Indexed universal life has cash value increases linked to the performance of an equity index (e.g., S&P 500®) up to a certain percentage (a “cap”) with downside protection (a “floor”). Some indexed universal life products have a guaranteed minimum interest rate of 2%. An indexed policy is structured to increase in value when the stock market goes up and will not incur losses if the market goes down.
A well-structured policy from a highly rated carrier will seek average growth comparable to returns on the S&P 500® index, with reduced volatility. Parents saving for college are considering indexed juvenile life insurance, to reduce the risk of a repeat of 2008 when the S&P 500® index fell over 24%. According to the non-profit Juvenile Life Insurance Foundation, financial planners recommend juvenile life insurance to help families pay the rising costs of higher education since it has tax-deferred savings and investment features that compare favorably to other available options.
For example, a SPDR S&P 500® (an ETF that tracks the S&P 500Â® index) purchased on January 2nd 1996 (15 year period) with an initial contribution of $3,600 and subsequent annual contributions of $3,600 returned 4.46% (including reinvested dividends). A juvenile life insurance policy from an A+ rated carrier with an identical initial purchase date and identical annual contributions, returned 5.80% (including the cost of insurance). Although both products were “linked” to the performance of the S&P 500® index, the indexed universal product (with a cap of 15% and a floor of 0%) had superior returns, without risk of loss due to market performance.
In today’s risk averse environment, annuities, structured products and index linked insurance will play an increasing role in college savings plan and retirement planning as families seek to reduce volatility and still achieve their growth objectives.
James Olion, founder and CEO of New Amsterdam Life Insurance Foundation. Find out more about Saving For College and College Saving Plan quotes at newamsterdamlife.com.