The 5 Scariest Threats to Your Financial Future
While vampire, zombie, and Bernie Madoff costumes may be getting all the attention this time of year, it's the financial apparitions that really ought to frighten you. As a financial planner and The Irrational Investor blogger at MoneyWatch, I keep track of truly scary threats to your wallet. Here's my list (created with help from smart members of The Bogleheads online financial forum) of the five biggest personal finance boogiemen, plus my advice to make sure you won't fall prey to them.
1. ‘No Risk, Big Return’ Pitches
- They give you less than the actual stock market return, often by stripping out dividends and by throwing on annual income caps depriving you of the market’s best returns.
- They don’t give you the return in cash. You get an annuitized payout reduced by steep fees.
The spiel from the “financial professional” or insurance agent goes something like this: “How would you like to earn 8 percent with no downside risk and be able to take out your gains for retirement income tax-free?” What makes this pitch so scary is that it plays on our two most destructive instincts — fear and greed. With this promise, you’d never have to fear the pain many investors endured from September 2008 through March 2009 when their portfolios lost more than half their value.
I’ve investigated dozens of these claims. They’re always for insurance products such as equity indexed annuities, variable annuities, or whatever flavor of the month is promising market returns with “guarantees” on the downside. In slogging through them, I’ve found they share a mind-numbing complexity and a chance for the planner to earn great commissions (sometimes more than 10 percent), always serving the adviser far better than the customer.
The gotchas revolve around one or both of these:
Avoid It: Apply some common sense and realize that if this product actually did what was promised, institutions would be pouring in trillions of dollars. You can get the same average annual return if you buy the bonds and stocks on your own, plus you keep the money that would otherwise be lost to commissions, costs, taxes, and the insurance company’s profits. Remember the rule that anything that looks too good to be true almost always is. And never buy a product you don’t fully understand.
2. Being Underinsured
You need enough insurance to protect you and your family against a catastrophic event that could significantly impair your financial future. Yet many people go through life as though they’ll never get sick, have an accident, or die, either by not purchasing insurance or buying coverage with gaping holes. If you died tomorrow, would your life insurance policy provide enough income to meet the needs of your spouse and dependents?
Avoid It: Think realistically about which catastrophes could be financially devastating. Then get coverage proposals from multiple insurance agents. Buy enough coverage for what you can’t afford to lose; self-insure for what you can. Raising your deductibles will increase your out-of-pocket costs in the event of a claim, but will keep premiums down.
3. Risk Amnesia
Investors have short memories. With U.S. stocks up by more than 60 percent in the past seven months, recollections of last year’s plunge are fading, and many of us are feeling brave once again. Jason Zweig, author of Your Money and Your Brain, told me that “with all the years of research I’ve done on investor behavior, even I’m surprised at how quickly amnesia is setting in.”
Let’s look at the recent past. In 2007, after five years of a bull market, people felt gutsy and invested heavily in equities. Then, when the stock market plunged in 2008, they panicked and sold — just in time to miss the 2009 recovery. Now that the market is on a tear, investors are loading up on stocks to avoid missing out.
Avoid It: Think back on how the recent bear wrecked havoc on your emotions. Then, try to set a more conservative asset allocation in good times and push yourself to take a bit more risk in bad markets. If you use this strategy and rebalance when your allocations vary from your target by five percent, you’ll wind up buying in bear markets and selling in bull markets.
4. Speculation Mistaken for Investing
Investing is about long-term wealth creation and taking smart risks with your money. Speculation is about gambling and trying to find the next hot stock or time the market. When my son was in fourth grade, he was taught speculation in school by being forced to play the Stock Market Game. In this game, students start with a virtual cash account of $100,000 and compete to create the best-performing portfolio using a live trading simulation over a few weeks or months. William Bernstein, author of The Investor’s Manifesto, says “this game sends precisely the wrong signal to students: that investment is all about short-term returns and trading individual securities.” Put another way: It confuses luck with skill. Some feel the game teaches investor education, but I think my son was taught gambling. And many so-called investors mimic the game with their actual portfolios.
Avoid It: Speculation inevitably leads to excessive trading, higher tax bills, lower returns, and too much risk. Instead, buy a diversified low-cost portfolio, and rebalance it periodically. This strategy isn’t exciting, but it works.
5. The ‘Free Meal’ Education Seminar
You may have received an invitation to a financial seminar with a free meal at a fine hotel or restaurant and the reassuring words such as “nothing will be sold” or “leave your checkbook at home.” I love to attend these events whenever I can because they usually give me great material to write about. Of course they’re selling financial products. The speaker might be a broker eager to manage your money or a financial planner/insurance agent selling a can’t-lose insurance scheme (see Scare 1). Indeed, the Securities and Exchange Commission just charged three brokers and a real estate promoter with using free meals to lure 90 people into a deal that cost them $12 million.
The hosts are usually masters of applied behavioral finance who know exactly how to convince audience members to become customers and say, “Take my money, please!” They don’t want you to bring your checkbook because, by law, they must first give you time to read the documents before signing something saying you’ve read and understood them.
I’ve found that there is an inverse relationship between the quality of the food and booze served and the quality of the financial products sold. That makes sense, since the biggest rip-offs make the most profit, which can then be plowed back into marketing costs, such as free lunches.
Avoid It: Know how to separate bogus invitations from legitimate ones. If the invitation is from a college or another nonprofit, it’s probably on the up-and-up. Otherwise, attend the seminar only as a teachable moment revealing how our emotions can be used against us. Go with a spouse or a friend acting as your “don’t buy anything” buddy, and don’t give out your phone number. Believe me, the once-in-a-lifetime opportunity will still be available next month — and the next month, and the next . . .
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