Monday, July 12, 2010

Investment Math That Most Financial Advisors DON’T Understand

Investment Math That Most Financial Advisors DON’T Understand

Compare these two equations:

Now what if I told you that the first equation was LESS than the second? I wouldn’t blame you if your reaction were something like, “You must crazy! How in the world can this guy say that 30 is less than 30?” That has always been the initial sentiment expressed by most people who have heard me discuss this concept.
This is a vitally important concept that you must know – and understand – in order to make any positive headway with your investment portfolio, especially given today’s stock market condition. I am willing to bet that without this knowledge, your chances of becoming financially comfortable during retirement are rather slim to none.

Let me explain.

Let’s assume that you invested $10,000 in the stock market via individual stocks or mutual funds of some sort, and the first year the market gained 20 percent. You gained $2,000, so you’ll end Year 1 with a total of $12,000. Now, all things being equal, if the market happens to lose 10 percent the following year, your balance will whittle down to $10,800, because you lost 10 percent of the $12,000, or $1,200. If the market performs well again the following year and you gain another 20 percent, you’ll end Year 3 with a total of $12,960 in your account.

Here’s the part that will blow you away. It’s what I call the common-sense strategy where, instead of investing the way most people are doing – which is getting them nowhere – you linked your $10,000 to the appreciation of the stock market index with a guaranteed minimum interest rate (let’s assume 0% for this illustration) and an upside cap (which we’ll make 15 percent for this example). What would have happened to the same $10,000 at the end of those same three years? Like they say, seeing is believing – so why don’t we do just that?

In the first year, even though the index returns 20 percent, your gains are capped at 15 percent. So you’ll end Year 1 with a total of $11,500. In Year 2, although the index sinks by 10 percent, your minimum guarantee is 0 percent, so you still have the $11,500 intact. You may be starting to recognize the power of this seemingly simple strategy, but let’s complete Year 3. Say the stock market index gains 20 percent, so you’ll gain up to the cap of 15 percent, which increases your balance to $13,225.

At this point, it should be pretty clear that the common-sense strategy generated the higher balance of $13,225, versus $12,960 under the exact same sets of circumstances, in the same market conditions, following the traditional strategy of investing directly in the market. Aren’t peace of mind and a good night’s sleep better than losing sleep stressing over investment woes associated with the directly-in-the-market approach? And what is even more challenging, in my opinion, is that you have no control over those market forces that are causing you all that stress.

Now you know that the same 30 percent net result really is not the same. The reason I mentioned in the title that most financial advisors don’t understand this basic math is simple. I personally find it extremely difficult to comprehend how such bright and – seemingly honest – individuals could understand the differences in these two approaches and still implore their clients to subject their hard-earned nest eggs to the unnecessary gambling associated with traditional in-the-market investing.

For those of you in the DC area, I will be teaching a workshop that is sponsored by the Maryland Women’s Journal where I’ll be explaining this and other simple, actionable strategies you can implement right now to build a truly secure financial future. The workshop will be held this Saturday, July 17, at the C. Burr Artz Library in Frederick, Md., with encore presentations in College Park on July 24 and in Columbia on July 31. Get details and reserve your free seats now! Invite your friends and family to join you, and be sure to come say hi to me.

If you are outside of these locations you can still request a complimentary consultation by visiting our website or calling 301.949.4449.

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