The
market may be the absolute best place to invest over the next few
years or the absolute worst. The fact is we cannot predict what
the future will bring.
Risk Management - The Traditional
Approach
Stock market risk is conventionally
dealt with by retention, with an attempt to minimize and control
it through diversification, asset allocation and having a long-term
time horizon. The problems associated with this means of risk management
for stocks/mutual funds are well documented and give investors a
false sense of security, especially when overall markets are unchanged
or increasing as they were in the 1990’s.
Asset allocation, diversifying investment
funds between stocks, bonds, cash and other areas (such as real
estate), helps to reduce risk but does not protect the investor
from dramatic downturns in the market.
Risk Management - The PM Investments
Approach
The primary objective of an intelligent
investment strategy should be to preserve capital and build upon
it at a consistent, moderate rate in both bull and bear markets.
So what do we do about market risk?
There are four things we can do: avoid it, attempt to control or
minimize it, retain it or transfer it.
Avoiding Risk
If we are concerned about a plane
crash we don’t fly.
If we’re concerned about
stock market risk we don’t invest.
Controlling Risk
If we are concerned about our
health we watch our diet and exercise.
We try to minimize market risk
by asset allocation and diversification.
Retaining Risk
We decide to take the risk that
our $50 lawn ornament will be stolen.
We decide to invest all of our
401-k in our employer's stock.
Transferring Risk
We buy a homeowners policy to
transfer our risk of loss by fire to an insurance company.
We buy a market-linked investment
to transfer the risk of loss in the market to the issuer.
The majority of people who have money
to invest put a substantial portion into the stock market. The minority
chooses to deal with stock market risk by complete avoidance. But
there is an opportunity cost in missing out on the sometimes-exceptional
gains that investing in the market can provide. The answer
to this dilemma is to transfer the risk of being in the market to
a third party.
When you transfer the risk of loss of
your house to a third party you pay a premium, even though you hope
you never have to submit a claim. When you transfer the risk of
market ups and downs to a third party you continue to hope that
the market goes up in the long run even though you may not receive
100% of the increase. The fact that you may not get a return as
high as the overall market is the “premium” you pay
for the guarantee on the principal of your investment.
Tools of Risk Management
There are a variety of tools that can
be utilized to intelligently design an investment strategy that
creates protection from the usual risk inherent in investing in
the market, while allowing for potential growth that is tied to
market performance.
The primary tools utilized by PM Investments
are Equity Index Linked investments. These allow investors to benefit
from the potential growth of the stock market while limiting risk
to their underlying principal.
Each person who has saved and accumulated
wealth and invested has had to choose between these two options:
- Give up a degree of safety in return for greater opportunity
for growth, or;
- Sacrifice growth opportunity in return for a higher degree
of safety.
Equity Index investments provide a third
option to consider, one that offers the power of money in
the market with the comfort of money in the bank.
Equity Index Linked Notes
Issuers of principal-protected equity
linked notes such as Merrill
Lynch, JP Morgan Chase, and Citigroup promise to return at least the original investment,
regardless of market performance, at maturity. Unlike bonds, however,
principal-protected equity linked notes generally pay little or
no periodic interest. Instead, at maturity, the issuer of the note
repays the original principal of the note plus an amount based on
the appreciation of the underlying stock index (such as the S&P
500). Terms of the notes vary widely and they are based on a variety
of indexes including sector and foreign indexes. Equity Index Linked
Notes are subject to the creditworthiness of the issuer.
Market Index Linked Certificates
Of Deposit
Unlike traditional CD's that pay a fixed
rate of interest, the market rate CD is linked to the performance
of a participating stock market index. If the market goes up, the
investment does too. Yet, regardless of what the market does, the
investor will get back the original principal amount at maturity.
In addition, the principal is FDIC insured up to $100,000 per depositor
per depository institution. Any gain in the Market Index CD is the
obligation of the issuing bank and is not insured by the FDIC.
Historically, these CD's have been issued
for a term of 5 to 10 years. However, the issuing bank usually provides
for quarterly redemptions after the first year. The Market Index
CD is designed to be a "buy and hold" investment and is
therefore subject to the risk of possible loss of principal if redeemed
prior to maturity.
An investor in a market index CD can
participate in the upside associated with an increase in the market
with a FDIC insured guarantee of principal.
Equity Linked Index Annuities
These tax-deferred contracts are written
and guaranteed by insurance companies. There are many different
terms and variations available and some offer the flexibility of
allocating among several major indexes. The more attractive contracts
offer annual compounding, no ceiling on the amount of gains as well
as an annual reset provision. The reset provision allows the index
credit to be added and "locked in" on each anniversary.
It can never be taken away, regardless of future index performance.
Annuities are designed for longer-term needs such as retirement.
Most will allow for additional deposits of as little as $100. Equity
Linked Index Annuities are not FDIC insured and have no bank guarantee.
They are subject to the creditworthiness of the issuing insurance
company.
Equity Linked Life Insurance
These contracts provide an appealing
alternative to traditional life insurance policies that accumulate
cash value. The more attractive policies offer a minimum guaranteed
annual rate (such as 3%) as well as offering the potential to earn
a percentage of the performance of a major stock market index such
as the S&P 500. Most policies provide an annual reset feature.
Cash value life insurance is purchased for long-term goals including
retirement and estate creation.
Conclusion
PM Investments strategy is primarily focused on
preserving capital and building on it at a consistent, moderate
rate in both bull and bear markets. To achieve this objective, we
primarily use market-linked investments. These investments are particularly
suited for investors who have an investment objective of principal
protection with long-term growth potential. They are not suited
for investors who have the objectives of current income, need for
liquidity, or who have an aggressive/speculative risk profile.
Protect Money (PM) Investments
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