Time after time, the stock market has proven that investors who stayed the course throughout good times and bad have been rewarded with decent returns, while those who tried to outguess the market have been punished. Computer investment models almost universally tell you that the best investment approach is take a long-term focus and ignore short-term swings. Good advice. The problem is the computer is asking people to make rational decisions, but most people make normal decisions, which means our emotions affect our judgment.

The road to financial success – quit reading

I have read that an investor using the Internet can access almost 300 billion pieces of financial information. The problem is having all this data does not result in wiser decisions, but instead leads to overconfidence, inaccuracy and confusion. Indeed, studies have shown that decisions get worse as our brains reach information overload, and this is a problem for investors and the professionals that advise them. This excess information goes to work on our greed and fear impulses and causes us to overreact. This overreaction means we buy high and sell low.

Fighting fear and greed with index annuities

An index annuity takes the consumer largely off the emotional roller coaster because it removes the dips in the track. The worst you can do is earn no new index-linked interest, but you get to keep the money you already have. This works to minimize the “sell low” fear signals we get during every market crisis. However, the siren song of potential investments gains calls to our greed side.

One of the rips used against index annuities is that you don’t get all of the upside. An index annuity interest rate does not take into account reinvested dividends, and you rarely get full participation in the index. Indeed, the effective participation rate of the better index annuities is often 45 percent to 55 percent. However, when you take away the dips, and turn stock market losses into a worse case of not losing what you have, you don’t need as much participation in the good years to get a competitive return.

A study conducted by Jeremy Siegel of the Wharton School found the average annualized return of the entire U.S. stock market for the period from 1946 through 2004 was 6.83 percent – including reinvested dividends. If you take the major index returns for the same period, do not include reinvested dividends, treat negative return years as zeros, and apply a 50 percent participation rate to the up years (an annual reset approach), your annualized return is 5.94 percent. With this approach, you earned 87 percent of the stock market return and were able to ignore the roller coaster bear market dips of 56-57, 61-62, 66, 68-70, 73-74, 80-82, 87, 90, and 00-02.

The 5.94 percent return is hypothetical. However, I looked at a few actual earned index annuity returns for the 10-year period ending this past summer and compared them with the annualized return of the largest index fund. For the last 10 years the annualized return of the index annuities I reviewed were 80 percent to 90 percent of what was earned in the index fund. With the index annuities you would have been able to thumb your nose at the millennium bear market that occurred in the middle years.

Index annuities are for normal people

None of this is to say that index annuities are designed to compete with stock market investments. Index annuities are safe money places that are alternatives to savings bonds and bank CDs (and the index annuity returns I looked at were 35 percent to 50 percent higher than the average CD or savings bond return for the same 1997-2007 period). The problem with investing is investors tend to act normally, which means they often act contrary to what the computer investment model says to do. For normal people that aren’t computers, index annuities make sense.

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