With the Standard & Poor’s 500 Index (S&P) dropping over 11 percent in the second quarter of this year, many investors are still fearful of the stock market. Consequently households, businesses and hedge funds continue to hoard cash at record levels. In exchange for this flight to safety, investors must settle for some of the lowest interest rates ever seen. In the face of this vexing risk vs. return dilemma, clients are wondering what to do.
Whether it is Federal Deposit Insurance Corporation (FDIC) insurance or some other form of federal government backing, investors are clearly putting a premium on guarantees. On the bright side, the Dodd-Frank Wall Street Reform and Consumer Protection Act permanently raised the FDIC coverage limit. For certain account types, the $250,000 limit was scheduled to expire and return to $100,000 in 2014. With the passage of this legislation, the $250,000 limit is now permanent.
On the negative side, the investment world and the world at large offer few guarantees. Unfortunately, they are usually for undesirable results, such as death and taxes. Investment literature repeatedly tells us that past performance does not guarantee future results. The past, however, does provide one certainty about the future: It is rather unpredictable. It therefore follows that future results are easier to guarantee the lower we aim.
Example: Let’s assume a treasury bill (T-bill) guarantees a 0.25 percent yearly return. When inflation exceeds one percent, the T-bill rate guarantees that your client’s money will lose purchasing power. Annuities offer some guarantees, but the handsome fees they impose can guarantee sub-standard results. If your client is only guaranteed minimal returns, is this what they really want? Or, should they be seeking a reasonable approach for optimal results instead?
Cautious savers have difficulty seeking optimal results due to the risk involved. Loss aversion is a powerful deterrent. Yet, in the long-run, this aversion may be a deterrent from more gains than losses.
Example: In a room filled with over 500 financial advisors, the following bet was offered: heads you win $120, tails you lose $100. Only a handful of them would take the bet. That’s the power of loss aversion: People, even financial pros, tend to strongly prefer avoiding losses to acquiring gains. Consider if the bet was offered to your clients 1,000 times. Wouldn’t the odds lead them to come out ahead? The expected statistical result is that they’d lose $100 x 500 and win $120 x 500; therefore your clients would gain $10,000.
Taking risks is a very smart thing to do if the odds are in our favor and we can take the same risks repeatedly. Statistics dictate that, over time, your clients will come out ahead.
It’s just like a casino — if we own it, of course. The casino doesn’t care about the outcome of any particular play by any particular gambler. It only cares that the odds are in its favor and that people play as much as possible.
When it comes to investing, savers seek guarantees. Investors seek optimal results by playing the odds in their favor. Disciplined investors benefit from favorable odds by playing them repeatedly. And speculators simply bet against the odds.
As clients turn to their CPAs for our opinion about their risk/return conundrum, we can help them tilt the odds in their favor and be disciplined investors. To that end, we must base our advice on the larger context of their personal lives, such as their specific goals and their time-horizon. Guiding clients to best use their opportunities to maximize what is important to them will encompass their personal:
- Willingness and
- Need to take risk.
This process may seem complicated, yet CPAs have a tremendous advantage in becoming be the most effective advisors in long-term financial planning. (see An Investor’s Best Friend).
These days, many people would rather settle for simple guarantees. However, with qualified help, such as counsel from a CPA, PFS (Personal Finance Specialist), an optimal approach can be planned to attain financial goals. As a CPA, you can pursue the PFS credential or create an alliance with a CPA, PFS. The help you provide clients in pursing optimal results can make a critical difference.
A flight to the safety of guarantees can, in the long-run, jeopardize the attainment of long-term objectives. Simply put, short-term fears can impede long-term hopes. Certainly, the future is uncertain and many risks should be avoided. However, to attain personal financial goals, it is far better to have a reasonable chance than an unreasonable expectation — or even worse, a guarantee to fall short.
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Jean-Luc Bourdon, CPA, PFS is a wealth manager with Walpole Financial Advisors, LLC (WFA) in Goleta, CA. His opinions and comments expressed within this column are his own and may not accurately reflect those of WFA. This information is being provided for informational purposes only and does not constitute investment or tax advice. Nothing in these materials should be interpreted as implying the performance of any client accounts or securities recommendations. Bourdon volunteers as financial literacy advocate. He also currently serves on the UW-Platteville’s Distance Learning Alumni Advisory Board. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter apply to become a PFS Credential holder.
The AICPA’s Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. The Personal Financial Planning Section is open to all Regular Members, Associate Members and Non-CPA Section Associate Members of the AICPA. If you are a CPA who wants to demonstrate your expertise in this subject matter, become a Personal Financial Specialist Credential holder. Visit www.aicpa.org/PFP to learn more.