The price of safety 
Is the penalty you pay 
When you change your mind

Financial journals often publish criticism about how actively managed portfolios generally underperform investments in S&P 500 index funds. Active management, therefore, must be failing investors.

What these publications miss is that the reason to actively manage a portfolio is consistency of returns, not matching index growth and volatility.

If a portfolio is taking less than market risk, it will also have less than market growth. Less risk means less chance of loss. Less loss potential and less growth potential means a lower variance (aka standard deviation) in returns.

Lower standard deviation means greater consistency and greater predictability. The more predictable something is, the more likely a plan will be to work.

How does an investor reduce risk and shift from growth to consistency? By using instruments that provide guarantees against loss while promising something greater than 0% growth.

For example, as of this writing, a person could invest in a 52 week Treasury Bill yielding about 5%. Treasury Bills are backed by the full faith and credit of the United States. Practically speaking, they have a 0% chance of loss. The US Treasury is providing a guarantee that it will pay the bond interest and return principal when the bond matures.

5% looks meager compared to 9.82% historical return on the S&P 500 (from 1927-2022). But the S&P 500 provides no guarantees of anything except the unexpected.

After one year the bond investor will have 5% more money from that slice of her portfolio than she started with. 100% of that growth will be taxable at the investor’s ordinary income tax rate. Whatever’s left is her net gain.

If we assume the investor has done the work to determine what kind of rate of return she needs from this part of her portfolio, and her net gains achieve her desired rate, she will have that most treasured of things: enough.

But, safety has a price.

Take our one year bond. The bond has a purchase price, but it also has a hidden cost: the investor’s commitment to stay invested in the bond for one year.

What if, during the 1 year holding period of the bond, the Fed raises interest rates? Now there might be 52 week Treasury Bills paying 5.5% instead of 5%.

If the investor has failed to put in the work to determine whether this investment aligns with her financial needs and values, she might chase the higher yield.

What happens to the market value of a 1 year bond yielding 5% when other 1 year bonds are paying 5.5%? It is worth less on the market, so it falls in price. Chasing an extra 0.5% yield might mean losing money when selling the 5% bond. If the investor isn’t careful, she might lose more money by selling the bond early than the extra 0.5% of yield will generate.

Instead of bonds, investors seeking safety and yield may purchase a CD from a bank. If the investor pulls his or her money out of the CD before it matures, the bank charges them a penalty. Similar to the bond, the safety of the CD requires a commitment of time from the investor.

Insurance products generally show up in a portfolio when an investor is looking for safety. Income annuities can provide guaranteed income for the investor’s life while fixed annuities and fixed index annuities can shelter investments from losses while growing at either a fixed rate of interest or by tracking indexes.

Fees for these instruments can be as low as 0%, but just like the 52 Week Treasury and the bank CD, these instruments require a commitment of time.

An investor does not buy or sell annuities or life insurance on a stock exchange, (aka a secondary market). Instead, insurance products are bought and sold directly by insurance carriers.

If someone owns an annuity and wants to get out of it, the account owner must sell her contract back to the insurance carrier. There is a special term for this transaction: “surrender.”

Similar to the maturity term of a bond, an annuity will have a surrender period. Depending on the annuity, this period can last from as little as zero years to up to 15 years. Generally, the longer the commitment, the greater the potential for growth.

If the annuity investor wants all of her money bank while the contract is “in surrender,” the insurance carrier will charge the contract owner a penalty equal to a certain percent of the contract value. These penalties are called “surrender charges.”

Bonds, CDs, and annuities represent only three instruments in a vast and complex ocean of risk-management strategies. Is there a framework to help make things easier to understand? I believe there is.

Keep these two rules of thumb to keep in mind when looking at anything that promises to reduce losses in your portfolio. There will always be exceptions, but for most people these rules will always hold true:

1) To increase safety, the investor must reduce growth.

2) To increase safety, the investor must decrease liquidity.

In the distribution phase of life, mistakes carry greater weight than they do during the accumulation phase. Depending on the person, mistakes during distribution may mean greater financial constraints, a decrease in autonomy, or an unwanted dependence on resources provided by loved ones or the government.

The remedy for mistakes is education.

Understand what you’re getting into. Know the time commitment required of any investment instrument and what kind of return or yield you can expect from it. Also, be sure to ask what happens if you pull some or all of your money out of the investment before it matures.

Helping people understand where they are, what they have, and how to get where they want to go is at the crux of all our work. If you are unsure how to navigate the distribution phase of your life and are concerned about the cost you might pay by making a mistake, we’d love to hear from you.