Fear-Based Investing…Never a Good Idea (S3 E10)

Transcript

I would argue that fear, even more so than greed, is the biggest hurdle investors face when it comes to sticking to a disciplined long-term investment strategy. For most of us, the pain of losing a substantial amount of money stings much harder than the high of hitting a homerun on an investment. The financial services industry is well-aware of this, and as a result, creates products and strategies to prey on these fears. Although there may not be anything I can say that will ever eliminate these from your thoughts, hopefully this episode will serve as a reminder of why anything in the investing world that sounds too good to be true…probably is.

Welcome to the third season of Invested Poorly: Sad Tales of FInancial Fails, now part of the Bold Departure Network. Invested Poorly is a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with the show.

I’ve never met anyone who likes to lose money. Unless you are a financial masochist and your goal is to make your life as hard as possible, what kind of rational human being likes to lose money? But if you are going to invest, then losing money, at least on paper, is going to happen a lot. I remember I had a client who always knew what the high-water mark was for his accounts. Whenever his total account value dropped by more than 5% from that number, I knew a phone call was coming. He always needed to talk to someone about what was going on and whether or not something should be done.

Honestly, it was hilarious because sometimes I could point out to him that his accounts had dropped all the way back to where they were a full six or seven weeks ago, or something like that. It was so frustrating because just a short time ago, his accounts were at all-time highs, and he was as happy as could be. But somehow a month or two later there was something to be worried about, despite being at the exact same value. This is one of my favorite examples of how irrational investors can be.

Unfortunately, as crazy as this sounds, reactions like this are common because we all have a different level of risk tolerance to handle stock market volatility. I shared another good story that drives this point home in Episode 3 of Season 1 where I talked about saving versus investing, so check that out if you are interested. It’s linked in the show notes.

Sadly, for those of you out there with a very low level of risk tolerance, the financial services industry has you covered. They have created a host of products that will assuage your investing fears by promising to eliminate, or greatly reduce, your potential for loss. Many of these come in the form of insurance products, while others use sophisticated financial products that require a much higher level of understanding. Unless this is the first episode of Invested Poorly you are listening to, you probably know what I’m about to tell you, which is that pretty much all of these products should be avoided.

The first fear-based strategy I want to discuss involves the use of stop-loss orders. Whenever the stock market dropped by more than 10%, I would always get a phone call or two asking why we didn’t just sell after a 5 or 6 percent drop. I mean the logic is pretty straightforward right, why not avoid a big loss by limiting your loss to a smaller one? The problem is, how do you know when a small loss will turn into a big loss?

So whenever I got this question as a financial advisor, my follow-up to the client was always to ask them what they wanted to do after we sell. I’m telling you, never once did I get a response from someone who had thought about that part of their idea. Usually, after a couple seconds of silence, I would simply ask, how will we know when it is safe to get back in? By phrasing it this way it got them to realize they didn’t have a strategy for getting back into the market, they just didn’t want to see their accounts go down anymore.

According to Standard and Poor’s, the S&P 500 has averaged 4.6 declines of 5% or more every calendar year since 1980. So after I would explain to them just how frequent small pullbacks are, they usually realized their “market timing” plan wasn’t as foolproof as they thought.

Unfortunately, some financial professionals who get comments like these use them to their advantage by selling products that limit losses. These come in the form of insurance-based investment products. Seriously, I could do an entire season on all the flavors these come in, but instead I’d recommend you take my inquisitive little nephew’s advice and “search it up.” You will find plenty of articles on these products, with comments discussing their merits and drawbacks.

Usually, the articles in favor of them are written by insurance agents selling the products; the articles opposed to them are written by pretty much everyone else without some type of vested interest in them. You can choose for yourself who to believe.

The point is these insurance-based investment products usually offer a perception of above-average returns with little to no risk. The way they go about this is different across contracts and if you want to sift through the more than two- or three-hundred-page disclosure, they will gladly explain how…Yes, that is my little dig at these products. I absolutely think it is a fair question to ask anyone selling these: why does it take so many pages to explain how they work if the insurance agent makes it sound so simple? Again, read some articles out there and decide for yourself if these products are in your best interest.

I’ll give you a couple of stories from my experience with these. One involved my dad’s friend who asked me about an insurance product his financial guy was pitching. It was an equity indexed annuity that promised to capture the returns of an index like the S&P 500 while limiting losses.

This sounds great, doesn’t it? Equity like returns with no downside; sign me up all day long. Of course, this isn’t how it works. Again, these are all different, but the annuity he was being sold had an 8% annual cap with a 0% floor. What this means is if the index returned more than 8% in a calendar year, he would only get 8%. If the index lost money in a calendar year, he would get 0%. By the way, it took well over 200 pages to explain that in his disclosure document, but I’ll move on.

I used the same strategy every time I came across one of these. I’d look at the specifics of the contract, download the last 30 or more years’ worth of stock market data and then throw it into a spreadsheet to illustrate what would have happened if the annuity had been purchased 10 or more years ago. In almost every case, the returns would have been closer to whatever money market or short-term bonds had delivered over the same time period, not the stock market. Trust me, the insurance companies know this, which is why they offer the products and pay their agents handsomely to sell them.

Although there are scenarios where these products could outperform a low-cost index fund, history shows they are few and far between. However, the one thing these products do offer, that the index fund cannot, is a lower volatility profile. For some people, the inevitable drops in the stock market are unbearable. If you are one of these nervous nellies who freaks out every time the stock market takes a hit, an insurance-based investment product might actually improve your return.

But regardless of your risk tolerance, make no mistake about it, these products do not offer the appreciation potential of the stock market over long periods of time. So don’t let a crafty insurance salesperson lead you to believe otherwise.

Another product I saw being peddled during my career came from an investment management firm that had somehow gotten involved with a group of high-net-worth investors. This group had annual meetings and would often bring in financial experts on various topics that were relevant to the members. One year they brought in an investment guy who pitched a product that blew the group away. One of the members was a client of mine, so he asked me what I thought of the strategy.

So this was a new one for me when first I saw it. This investment professional started off his dog and pony show by throwing insurance agents under the bus in an effort to gain the group’s confidence. Obviously, you can tell I’m not a fan of insurance-based investment products and I think a lot of investors are suspicious of these as well. By first addressing the group’s likely skepticism of insurance products, he immediately gained a bit of trust. After that, he shifted the presentation to illustrate how a traditional investor could capture the positives from an insurance product, like a guarantee of no loss of principal, while still having the upside of stocks. His solution was to use a combination of U.S. Treasuries and options.

Don’t worry, I’m not going to bore you to death with the strategy, but instead I’ll give you the idea he was peddling. His strategy was to take an investment amount from a client, let’s say $100,000 and first purchase a zero-coupon U.S. Treasury bond with a maturity date a couple years out. You see, when you buy a zero-coupon U.S. Treasury bond, you purchase it at a discount to the face value it will eventually mature at. So in this very simple example, he might have been able to buy a zero-coupon bond for around $90,000 that would mature two or three years later at $100,000. Since U.S. Treasury bonds are guaranteed, you can see that no matter what happens, he will get back the original $100,000.

Now for the fun part. What was he going to do with that other $10,000? His strategy was to trade options. Again, I’m not going to get into the nitty gritty details of option trading, but at a high level, options offer investors the ability to control a large amount of stock with a small amount of money. The gain/loss profile on many option strategies is very high. So basically what you are doing is investing in a strategy that promises to give you your money back after a couple of years, with the hope of making you even more money than you started with, by allowing an investment professional to trade options. I’m not saying this will never work, but it sounds an awful lot like market timing to me.

I discussed my views on market timing, which are quite frankly not very favorable, in Episode 7 of Season 1. I’ve linked to that episode in the show notes. Of course, the advisor selling this strategy had a very lucrative fee for the service, similar to that of most hedge funds at around 2% of the account value per year and 20% of the profits. My professional assessment of this strategy is that you are effectively paying a huge fee to let someone gamble with your money. No thank you, if you ask me.

There is no doubt about it, fear is one heck of a motivator when it comes to your investments, almost always in a bad way. Hopefully this episode reminds you that your ability to control this fear—not pretend you can eliminate it—will help you avoid unnecessary pitfalls on your FI journey. I can’t think of a better way to end a podcast episode on fear and investing than by reminding you to always…ignore the noise.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen!” So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell. Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.