Money Management & Retirement Planning Advice by Barry Unterbrink, Chartered Retirement Planning Counselor

Thursday, March 04, 2010

The 7% Solution (revisited)

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

This blog post was originally posted in September, 2008 near Dow 11,150; it's now updated through 2009. The market has fought back hard since the low's one year ago. If you've invested in stocks, you should be ahead nicely year over year. But what now? Perhaps employing a "safe money" strategy is prudent now with a portion of your money. Read on.

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, wagering is never a sure thing, but you can weigh the odds by using past data. 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 20% since its high last October (2007). I'm using this 7% figure to compare stock price performance vs. a hypothetical 7% rate of return, what's available in a fixed index annuity. The answer sought: is it generally better to accept the market risk of stocks (gaining above in any one year/decade, and also losing money), or to bet with the a less risky maximum 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. The floor is zero in the down years. You would never lose money in a down year with your principal. Dividends were not considered for ease of calculations. Eight decades of data were used, starting in 1930, and ending in 2009. This covered all of my available data, and represented co-incidentally about the lifetime of an investor, 80 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’s Stock market lost 24%, the 7% strategy gained 40%

Well, the tally is pretty easy to figure visually: being a long term investor in the stock market paid off more than the 7% annuity plan, but you needed a strong stomach to stay in during all the bad markets periods (25 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 one-half the time by decade, ‘30’s, ‘40’s, ‘70’s, and ‘00’s. The other 4 decades your stock portfolio would have bested the 7% strategy. Note also that all decades were winners for the stock market, except the '30's and '00's just completed. But - the 7% plan beat the market in the '40's and '70's due to truly bad years that reduced the average gains over the 10 year decade.

Taken all together, you earned about 2X more by following the market as a buy and hold investor. You may say, "that’s all history now, what do I do today?" My reply; if you are 10-15 years to retirement, keep ¾ of your money in the market, and ¼ in the 7% plan. If you are older and closer to retirement, keep less with Mr. Market, and more in the safer 7% plan. With the recent stock and credit market turmoil, you should look at your money allocations to determine your risks as you inch closer to retirement.

If you can't eat or sleep well, you probably need to consider changes. Call me and I can help you with that.

Barry Unterbrink, C.R.P.C.
(954) 719-1151
* source Ibbotson & Associates SBBI yearbook

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