Emotional Investing: Do Leave Home Without It

By

A producer recently told me the following tale about one of his clients who has flipped and flopped between the market and index annuities.

A little less than a year ago, during the period when the market had backed off some recent gains, this client came into the office and announced he was done with the stock market.

The client said he had moved into mutual funds in 1999 because of the tremendous growth of previous years, but now, after watching his funds dwindle, he had sold them all–because he realized “you always lose in the stock market.” He said he wanted to buy the index annuity that the agent had been suggesting. And so he did.

Then, last September, after the stock market had risen significantly, the client returned to the producers office demanding that the index annuity purchased 6 months prior be surrendered. The client said he had determined he could make more money in the stock market.

When the producer asked the client why he didnt think he would make the same mistakes this next time around, the client responded: “Because Im much smarter now.”

For financial professionals, this tale has several lessons. As in celebrity Garrison Keillors Lake Wobegon, where all the children are above average, we seldom admit the possibility that some of us are below average drivers, poker players or investors. When we do succeed we are more likely to credit our skill and prowess, rather than luck and circumstance.

To make things worse, we use our emotional compass as an investment strategy.

In 2000 and 2001, for example, consumers were in hope mode, whereby they did nothing when their investments fell a little on their way to falling a lot. Why? They hoped their investments would go back up.

Then, in 2002 and 2003, consumers entered fear mode. Many sold their investments, convinced that the bad times would continue forever.

Today, with a year of stock market increases behind them, consumers have re-entered the greed mode, determined not to miss out on the maximum possible gain and ignoring any risks.

But for the index annuity story to be successful in 2004, producers need to help disconnect consumers from this emotional investing cycle. One of the ways to do this is to set correct expectations.

If you use the phrase equity index annuity you set up a scenario for unrealistic return expectations. In greed times, the use of the equity word causes consumers to think of unobtainably high returns, and in bad times, equity makes consumers think of losses.

An index annuity is a fixed annuity with interest linked to the movement of an index. Over time, an index annuity is designed to compete with other safe money places. When talking to the consumer about potential index annuity returns, the comparison should be with CDs, bonds and other fixed annuities.

The wrong response to the greed mode is to feed it. However, there are those who disagree. Now that the market is up from the past 3 years, index annuity claims already are circulating about “possible 36% to 60% returns” and “youll average double-digit yields”–neither of which will happen.

Talk to your clients about loss and ask how well they cope. If they do not have the temperament for market risk and if they understand that protection from loss limits maximum potential gains, then an index annuity is an answer.

And, if an index annuity product claim is too good, challenge it and ask for supporting documentation.

An index annuity protects the annuity owner against loss of principal and credited interest from index declines.

The cost of this protection is part of the future potential index-linked interest. An index annuity does not eliminate uncertainty, but it does remove the risk of loss from the equation.

Fixed index annuities can help improve the odds of people receiving a competitive return. They do this by making it less likely a client will try to control the market by buying and selling at the wrong times.

is president of Advantage Compendium, a St. Louis-based research and consulting firm. He may be reached at webmaster@indexannuity.org


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 13, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.