Retirement Planning Advice and Financial Related Education by Barry Unterbrink, Chartered Retirement Planning Counselor

Monday, September 29, 2008

The 7% bet ... is it prudent now?

Investing has always been a trade-off. Making choices with your money involves weighing the potential risk and rewards to determine the best course of action to achieve your desired goal. So, in a way, investing is akin to odds-making. In America, this is called fixed odds betting; wagering where you know the odds at the time of the placement of the wager. This is fairly easy to determine in the stock market since reliable statistics and performance are readily available for past sessions going back at least to before the Great Depression, or about 1925.

I thought it timely to undertake this market study now, as the stock market has fallen about 30% since it's high last October. I'm using the 7% figure to compare stock price performance vs. a hypothetical 7% rate of return, such as a deferred index annuity. The answer sought: is it generally better to accept the market risk of stocks (gaining above in any one year, and also losing money in any year), or to bet with the a less risky 7% annual return with no risk of loss when the stock market is down for any year.

To get started, I took the annual Standard & Poor’s 500 Index and compared this with a fixed index annuity that would credit you interest annually based on the performance of the S&P 500 Index with a cap of 7%. The cap is the maximum you could earn in any year, with a floor of zero in down years. You would never have a down year with your principal. Dividends were not considered for ease of calculations.

Seven decades of data were used, starting in 1930, and ending in 2007. This covered all of my available data, and represented co-incidentally about the lifetime of an investor, 78 years.The data presents itself as follows:

1930’s Stock market lost 41%, the 7% strategy gained 31%
1940’s Stock market gained 34%, the 7% strategy gained 40%
1950’s Stock market gained 257%, the 7% strategy gained 65%
1960’s Stock market gained 53%, the 7% strategy gained 50%
1970’s Stock market gained 17%, the 7% strategy gained 49%
1980’s Stock market gained 227%, the 7% strategy gained 66%
1990’s Stock market gained 315%, the 7% strategy gained 68%
2000-2007 Stock market lost 1%, the 7% strategy gained 31%

Well, the tally is pretty easy to figure: being a long term investor in the stock market paid off more than the 7% rule, but you needed a strong stomach to stay in during all the bad markets (24 years were down years). Using the 7% maximum gain in any one year, and all down years counted as zeros, you would have beaten the buy and hold market 50%, or one-half the time – ‘30’s, ‘40’s, ‘70’s, and so far the current decade. The other 4 decades your stock portfolio would have bested the 7% strategy. Taken all together, you earned about twice the amount by following the market.

You may say, “that’s all history now, what do I do today?” My reply; if you are more than 15 years to retirement, keep ¾ of your money in the market, and ¼ in the 7% plan. If you are younger, keep less; if older, keep more in the safer plan. With the recent stock and credit market turmoil, you should look at your allocations to determine your risks. If you can't eat or sleep well, you probably need to consider changes. Call me and I can help you with that.

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