Average Returns v. Actual Yields, & Why Whole Life is a Great Bet
December 30th, 2009 // 4:00 am @ Andrew Rosenbaum
Here’s a message for all investors who like playing with high-risk investments: Math is not money, and money is not math.
Imagine you are investing $1,000 in a mutual fund. You have a fantastic first year, earning a 100 percent rate of return, bringing your balance to $2,000.
In year two, things go poorly and the investment loses 50 percent. Your balance is now back to $1,000.
In year three, the market goes up and you earn 100 percent again, bumping your balance back up to $2,000. The fourth year markets tank again and you lose 50 percent. Your balance has now fallen back to $1,000.
Notice that your beginning and ending balances are exactly the same. Your actual yield is a big fat 0 percent.
Here’s the interesting thing. What is your average rate of return? 25 percent.
I know any investor would love to get a 25 percent return. A mutual fund with this exact performance could advertise, “Our fund has averaged 25 percent over the last four years.”
It’s a true statement. It is not illegal or blatantly dishonest. It simply fails to illustrate the fact that investors actually ending up with no return.
One of my clients is a major league hedge fund manager. He knows something about high-risk investments. But what does he have in his portfolio? A guaranteed contract –- a whole life insurance policy.
In the past year he doubled the size of his policy. In this economic environment, he told me, he needed to lower the overall risk of his investments. And a guaranteed contract is a smart alternative to treasury bills, which are currently paying a very low yield.
Here’s how he explains it in his own words:
Whole life is an investment with its own risks and rewards. But the risk is relatively low. The return is virtually guaranteed, you can borrow against it over time, and you can use it for estate planning purposes. I know that when I die my family will have enough money to manage their own lives. I could invest in ExxonMobil, but who knows what the stock would be like in ten years?”
He told me he thought that whole life has a bad rap, which encourages people to think they can outperform the policy. To quote him again,
Many savvy investors believe they can stimulate the characteristics of life insurance benefit on an after-tax basis – it has to be after tax because money accumulates within a policy tax-free. They think they can take $10,000 a year and invest it, but what happens is they never do it, and their portfolio is skewed.”
My hedge fund client really understands risk, and he certainly understands rewards.
Category : Financial Certainty &Financial Planning &Investing &Market Volatility &Permanent Insurance &Stocks & Mutual Funds
