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Retirement Planning > Retirement Investing > Annuity Investing

Return illusions -- risk and volatility

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* The charts referenced below appear at the bottom of the article

The top wheel has five possible outcomes with four of them returning 6 percent and one returning 1 percent. The bottom wheel also has five possible outcomes, but they range from 2 percent to 12 percent.

If you spin both wheels, which one is riskier?

If you ask people which wheel has the greatest risk, most people say it is the bottom one. And they are right if you only spin the wheels once.

On one spin of the wheel, the top wheel has a 20 percent chance of returning less than 6 percent and the bottom wheel has a 60 percent chance of returning less than 6 percent. On one spin of the wheel, the bottom wheel poses the greatest risk of low returns.

However, a consumer’s financial world does not consist of one spin of the wheel. A consumer is not taking all of his IRA money and betting it all on how the market does tomorrow. In reality, our financial world is made up of thousands of spins of the wheel.

Not understanding risk and volatility

If you spin our two wheels many times, the bottom one produces the higher return and is therefore less risky than the top one. Unfortunately, we assume the bottom wheel is riskier because it is more volatile, and because we see the future as one spin of the wheel at a time we confuse volatility and risk. Not understanding the difference between risk and volatility often sabotages financial plans by causing us to not maximize potential earnings.

Assuming safety means higher returns

Hand in hand with this is a belief that less-principal risky investments have higher returns. I have read several surveys asking retirees whether stocks or bonds produce higher returns over time and the majority choose bonds. Why? Because they believe bonds simply have to produce higher returns because they don’t go up and down as much as stocks.

Rules of thumb help annuity sales

Risk and volatility are two separate things, and there actually is a relationship between risk and return – taking higher investment risk does usually result in higher returns. But it doesn’t seem correct to most consumers that a vehicle that protects them from market loss should produce a lower return than one that does not.

However, the mental rules of thumb used by consumers help to put money into banks and annuities. Consumers are predisposed to assume that accounts wherein principal is protected and where they believe the earnings have less fluctuation will produce higher returns over time than ones that do not.

What does this mean to the annuity producer? If the producer is presenting a multi-year rate fixed annuity the consumer is seeing that as the “top wheel” and will be inclined to view it favorably.

If the producer is presenting an indexed rate annuity and trying to move money from the bank, the consumer is seeing the index annuity as the “bottom wheel” because of the possibility of years with low or zero indexed benefited interest. The producer needs to remind the consumer that they are not buying the annuity for simply next year’s interest, but are in for the long term, and to talk about how many spins of the wheel translates into more opportunities to earn more interest than the bank pays.

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