Transcript
Paul Winkler: And back here and The Investor Coaching Show, Paul Winkler. I mentioned that sometimes people get into a mode where they want to protect themselves and check their investments from downside risk and things like that. And I want to talk a little bit about a couple of strategies. So sometimes people use now—I see more often than I’d like to—is using annuities that are guaranteed against downside risk. And you know, a lot of times you’ll see some that are super, super expensive.
Downside Risk
Those will basically protect against if the market goes down—”we’ll protect you,, we’ll manage your risk.” And you know, like for example, you’ll have these death benefit riders where if somebody puts a hundred thousand in and the market drops and it goes down to 90 and you die, then your heirs will get a hundred thousand. So you’ll have mortality and expense charges on annuities that will do that. Another thing is just protecting it against downside risk when you’re alive and you’ll have income riders, which will be, as I’ve talked about before, it’s kind of a fake account. It only goes into operation if you actually start to take an income from the product. So you put a hundred thousand dollars in the market drops and your investments, or they just do poorly.
Maybe it’s not even a market-based investment, they just do poorly. And it goes down to $75,000. And then all of a sudden, you know, you’re starting, you look at it going, Oh my goodness, it’s $75,000. I put a hundred thousand in there, but you’ll have this income rider that says your account value is 125,000. Oh, good. I can take an income from $125,000. Then they’ll tell you how much income you can take. And that income is dictated by the insurance company. So in reality, it’s not based on the account value because if I took that $125,000 and I gave it to some other insurance company, if supposedly there were really $125,000 there, then the income amount that they would give me would be totally different.
So the question you have to ask yourself is, did they really increase your account value from a hundred, 225,000? So let’s just put some numbers on it just for just so you kind of get what I’m saying. So the insurance company says, we’re going to give you, we’re going to give you $125,000. That’s what your income is going to be based on that. And your income is going to be $5,000 a year, let’s say, and then you go, Oh, okay, $5,000 a year on a $125,000 account value. Well, what if I take my $125,000 and I give it to some other insurance company, well, you can’t do that. Well, what if I take my cash surrender value, which is $75,000.
Because it lost money. And it went down to $75,000 and I took that to another insurance company. And the other insurance company comes back miraculously and says, Oh, we’ll give you $5,000 a year and you go, Oh, wait a minute. That’s what the other company was going to give me for $125,000. Well that’s because that wasn’t real money. That was a Phantom account, which is literally what they call it in the industry. It’s a Phantom account. It doesn’t exist. Yeah. Oh great. Okay. So basically I was told that I was getting this guarantee that I really wasn’t getting. Yeah, that’s kind of it. So that’s one thing that they do is this. Let’s say if you have a hundred thousand dollars, you give it to them.
They take $70,000 of it and put it into bonds. And then they’ll take the other, you know, they took $70,000 and put in there and the other $30,000, they play around with the options contracts on the stock market, which can go up and down with the market and they can exaggerate the movement of the market, like options, contracts. You can have a situation where you put money in them and they expire, and they’re worthless. You can have a situation where they just kind of break even or don’t do much of anything at all. Or you can have a situation where you have some decent, really decent gains. If the market moves extraordinarily in the upward direction, and you can actually exercise the options and magnify some of the gains.
Options Contracts
So that’s the idea behind the options contracts, and what happens is they can say, well, we’re going to guarantee that you can’t lose money because the $70,000 eventually at some point in the future will be worth a hundred ways, which is what you put them in because the bonds will increase in value. And we don’t worry about them fluctuating in value, but you have to, may have to wait 10 or 15 years for that to actually happen. So if the options contracts don’t do that well, or they don’t move far enough, then basically you don’t have much of any kind of gain. And I’ve had a lot of that happen recently where people will come in and say, well, here, I got this annuity. I got so many years, 10 years ago, 15 years ago. And well, what was your return?
Well, basically just next to nothing. And I go, Oh yeah, okay. That happens a lot. And it’s because of the design issue that I’m talking about right here, you know, so you can have that type of a guarantee, but it comes at a huge potential expense, which is no returns. And this is something I always try to get people to really, really key in on is that when somebody tells you that they’re going to give you great returns with no risk run. Another thing you hear is this, well go, we’re going to do is we’re going to watch your portfolio. And we’re going to protect you against downside risk. If the market starts to go down, what we’re going to do is we’re going to sell out of stocks. We are going to move your portfolio around to protect.
What Is a Put Option?
Now, there are a couple of different ways to do it. Sometimes people will do it with options and they’ll do what’s called a put option. And a put option is where you pay a premium. And if a stock goes below a certain level, you have the option to sell it at a higher number. So let me put numbers on this. So I get a stock and it’s selling at $50 a share, and I buy a put option to sell it at $45. So the stock is selling at $50, and I’m not going to go and sell it at $45. That would be crazy. But I pay a premium to have the right to sell it at $45. When would I exercise that? Well, if it goes down to $30, you know, if the stock drops from $50 down to $30, I’ll just go, Oh my goodness, I lost a lot of money.
I went from $50 down to $30, but I have this option to sell it at $45. And I will exercise the option if it’s about to expire. And that way I’ve protected myself from some downside risk. Well, there’s a problem there when stocks are more volatile, when there’s more risk, typically those options cost more well since that’s a cost of doing business, that actually that actually hurts your upside potential. If the stock goes up in value, you’re not going to exercise it, right. If it goes from $50 to $60, you’re not going to exercise it. But what happened? You could have a big premium that you paid or a lot of money that you paid for the put option and your movement from $50 to $60 is actually reduced significantly by the premium that you paid for put options.
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Downside and Upside Returns
So that’s a drag on your returns on the upside. It can protect your downside, but it also protects you from upside. So you think about it. What just happened here? My volatility went down or that my potential for volatility, but my also my upside went down. So when I protect myself from downside risk, what do I do? I also protect myself from upside gain CCS. This is there’s no free lunch, really? When it gets down to it, another thing I hear is, Oh, you know, if, if the market goes down, we’re going to sell stocks. Well, what are you doing? You’re selling low. The market goes down. You’re going to sell low to protect my downside risk.
And then when the market goes back up, you’re going to start buying into stocks again. So you’re going to sell low and you’re going to buy high. And when are you going to buy again? When the market looks good again, when it goes back up, well, the market’s already gone back up and I didn’t benefit because I didn’t benefit when it was going up. That doesn’t make any sense. But you know, that’s, these are all things that people use in order to try to sell stuff to people. And, you know, people don’t realize this is a marketing game. You gotta be really, really wise as a serpent. When it comes down to it, you gotta understand that, you know, these companies come out with these things. They’re based on your, your mind, which is saying, stay away from pain and go toward pleasure.
Managing Risk
And what else will happen is they’ll come out with products that will sound really, really good. And it will give you what you think you want, which is I want all the upside return.
I don’t want any downside risk. And gee, that sounds good. Let me sign here. And then typically what happens? People don’t figure out that there’s a problem until you don’t like it.
I saw a couple of times this week: a decade into it, and all of a sudden you just go, wow, how much time have I lost? And, you know, the reality of it is a lot of times financial advisors are taken in by this stuff because they don’t, they’re just out there many times just selling whatever their manager told him to sell. I remember working for the big companies that I worked for, and we would have meetings on Fridays. Okay. How many prospects do you guys have? How many phone calls did you make? How many appointments did you get? How many closes do you have?
What’s your FYC, you know, your first-year commission and you had to report that and they shamed you into, you know, if you didn’t have a lot of sales that week, and it was, you know, shame on you, you didn’t work very hard this week, Paul, you know, you need to get out there and get it next week and sell some stuff. And, you know, I was talking to one of the, one of my buddies at the station he was talking about when he used to work in the industry, getting out there and setting up these programs, deferred comp programs, using life insurance policies and using them as an accumulation vehicle and the commissions that these people would make, or just off the charts. It’s not unlike this whole conversation we’ve been having recently about hedge fund managers and talking about how people are perceiving that these investors are really great at what they do because they only work with wealthy people, people think, well, if you’re working with wealthy people, you must be really good at managing money.
Managing Money
No, a lot of times wealthy people aren’t very good at managing their money, or they’re not very good at perceiving that something’s being mismanaged. You know, the example that I like to use is Bernie Madoff. Bernie Madoff did not invest money for poor people. He only invested money for very wealthy people. So what happens is people that get taken advantage of.
Don’t, don’t get caught up in wealthy people and how they manage money. And if they’re really good at well, you have these hedge fund people that may be living on Lake Michigan on some of the nicest property out there, huge mansions and very expensive properties and people that well, they must be really good at managing money in order to afford to live in a place like that. Don’t get sucked in by that kind of stuff. You know, there are studies that show that hedge funds. So a lot of them are really, really bad because if they don’t, well, they don’t report their returns. If they do well, they report their returns. If they don’t do well, they close them down.
If they do well, they stay open. So it makes them look like they’re even better than they are. And then they go and charge 2% of money under management, plus 20% of gains and no wonder they’ve got so much money. I mean, what a business model, that’s huge, you know, so don’t get sucked in by this stuff is really when it gets down to it. And I really, really feel the need to make sure that you understand that with investing, there isn’t the secret sauce where I can get great returns with no risk. You know, one of the things that Ira said last week, and I liked that he made this point was he made the point about, Hey, the reason I liked downside risk, I like markets going up and down because if they didn’t go down, then I wouldn’t have the return history that I have with stock markets.
Risk Is Involved No Matter What
You know, if there is no risk, then there is no need to pay investors any kind of a premium as we call it or extra expected return in order to take that risk. You know, we get compensated for putting up with things is another way of putting that. You know, if we look at putting up, well, let’s say, if you’re doing a job that’s really dangerous, you know, and they have these TV shows where these people are driving trucks across just incredibly dangerous, incredibly dangerous terrain. And they get really well paid for doing it. Why? Because they’re putting up with stuff. You know, you get people that go into hazardous occupations and they get more money for being in those hazardous occupations.
Why? Because they got to pay him that much to do it. They got to pay them that much to actually put themselves at risk. Or if we’re talking about, let’s say, if you want to be in a profession like being a physician or something like that, or you want to be an attorney, or you want to be a, you know, maybe you want to do something that is really, really difficult to get educated and go through the education process for while you’re putting up with something you might be putting up with 10 years of school. Well, if you’re going to put up with that many years of being educated and being in the education system, and then going through what a physician has to go through, for example, well, you better have some decent pay on the other side of that, or nobody’s going to want to go into the profession.
That’s just the bottom line that says life. We get paid more for putting up with stuff. And that’s just it. If you look at risk and return, they are related, you’re putting up with something and anybody that tells you that we’re going to protect you from downside risk. And you’re going to get upside return. We’re going to give you that kind of benefit. Like I said, just run, don’t walk, run, Paul Winkler.
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