When clients need guidance on how to invest
Even if you're mainly in insurance, you might still have clients who invest and might want a primer on investment basics.
As an employee benefits professional, you might also have clients with individual retirement plans, or clients with insurance products allowing some voluntary choice in how the money is invested. Variable annuities are a good example. In addition, you might have business clients that provide employees with 401(k) plans that allow them to choose how their contributions are invested, so you offer educational seminars for those employees. What do all these situations have in common?
Each involves people who may need guidance on how to invest.
Relationship between risk tolerance and asset allocation
Different people have different attitudes towards risk. Taking it to extremes, most people would agree, “I don’t want to lose any money,” and “I want to get the most possible.” Unfortunately, you cannot have it both ways.
Now let us change that first sentence to: “People have different tolerances for risk.” As you know, generally speaking, investment portfolios have three primary categories, sometimes called buckets. They are stocks, bonds and cash. The terms are pretty self-explanatory. Depending on how a person feels about risk determines the asset allocation. This works in the other direction too. The person who claims they wants safety but has riskier investments is out of balance. They either need to admit they are willing to take more risk or bring their investment mix down to the recommended levels.
Investing is generally approached from a long-term time horizon. However, this is not always the case. The employee retiring in a couple of years may be thinking about drawing on their retirement assets in the near term. Their time horizon is much shorter term.
What kind of investor am I?
It is important to realize historical returns vary by the asset mix and the degree of risk taken. Put another way, you cannot say “I don’t want to take any risk” and then expect high returns at a time when bonds are only yielding single digits. Risk means the possibility of losing money. Investors need to understand that.
Lets us consider five investor profiles. These are samples from my days in production. Your firm likely has their own versions.
1. Capital preservation (conservative risk). This is the person who says: “I don’t want to lose money if I can avoid it.” They might be described as “Put money in the mattress” people. They like bank CDs and money funds. These people would probably have close to 0% in stocks and the balance in bonds and cash. Since they likely can think long term and money fund yields are low, most of their money might be in bonds, probably short term.
2. Income (conservative-to-moderate risk). This is someone who believes you make money from collecting interest and dividends. They know some risk is involved, if they needed to sell a bond before it’s maturity date. Buying stock for growth represents a greater risk in their opinion. They might own a little stock, but it would be income producing shares like electric utilities. Their bonds might be of different maturities, but all paying interest. Cash would be minimal.
3. Growth and income (moderate risk). You have met people who when asked if they want chicken or fish for dinner indicate they want both. When asked for an opinion, they have one foot in each camp. They understand the concept of growth, but like the safety of bonds with set maturity dates and interest paid along the way. They are sometimes called balanced investors. They like stocks with growth potential that also pay dividends while you are waiting. These are total return stocks.
4. Growth (moderate-to-aggressive risk). These are people who are thinking long term, yet don’t want to go crazy with risk. They will have the majority of their money in growth stocks and a smaller amount in bonds. The bonds tend to act as a shock absorber in volatile markets.
5. Aggressive growth (aggressive risk). These are the people who enjoy skydiving. They are willing to take a high degree of risk to have the chance of getting an exceptionally high return. They take chances. Their portfolio might be 100% stocks or close to it, with a tiny amount of bonds and cash. They need to think long term. The stocks or funds they choose tend to be aggressive.
Where do percentages enter the picture?
Let’s look at those three buckets: stocks, bonds and cash. As you explain to clients, stocks are also called equities, bonds are referred to as fixed income and cash includes some bonds with very, very short maturity dates and are called cash equivalents.
Let us look at the middle of the road category: growth and income or moderate risk. As an example, that investor might have 60 cents of a dollar in stocks, 35 cents in bonds and 5 cents in cash. Their asset allocation would be 60%, 35% and 5% or 60/35/5. That is often referred to as the recommended allocation based on their risk profile. The firm might adjust the numbers from time to time based on market conditions and their economic forecasts.
The allocation varies for the different risk profiles. The model for the income or conservative-to-moderate risk investor might have a lower percentage in the “stock bucket” and corresponding higher percentages in the bond bucket and the cash bucket. The growth or moderate-to-aggressive risk investor’s model might lean more towards increasing the percentage in the stock bucket, with less in the bond bucket and the cash bucket.
Stock and bond prices change all the time. If the stock market goes up, the percentage in the stock bucket grows and becomes “overweighted” while the bond and cash buckets become underweighted. Why? Because the percentages must always total 100%.
A good advisor will periodically review the asset allocation with the client, moving money around to rebalance the portfolio or more accurately, bring the portfolio back into balance. If you are lightening up on stocks when the stock bucket is overweighted, you are taking money off the table when the market is higher. If the stock bucket is underweighted and you move money from the bond and cash buckets, you tend to be buying stocks when they are down in price.
Investing and risk go hand in hand
Deciding you want to invest in the stock market doesn’t mean you put all the money in one investment or fund. How you spread it out and your degree of exposure to the stock market is determined by your tolerance for risk. Your firm should have literature on this subject. If you are opening an individual account for someone, those risk tolerance questions are likely part of the account opening process. In all cases, these clients can benefit from professional advice.
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