Annuities vs Stocks
Annuities and stocks don’t typically come up in the same conversation. They are polar opposites as investment types and they don’t share many characteristics which would lead one to conclude that they really can’t be compared together as in “annuities vs stocks”. For many investors, it is not an either/or proposition, but, rather, it is a question of how much of both investments should be their portfolio because the combination is ideal for achieving essential balance. The overriding issue for all investors is which investment, annuities, stocks, or some combination, can best help meet their goals while keeping them in their risk comfort range.
The primary consideration for investors in making any investment selection should be the level of risk they are willing to assume, and when doing so, they should consider all forms of risk. The category of risk that seems to get the most attention is market risk which is when your original investment is subject to up and down fluctuations and there is the potential for loss of capital. A big mistake many investors make is not considering all of the other forms of risk which could also threaten their capital. Since we are exploring the annuity vs stocks proposition, this would be a good opportunity to weigh these two very different investment types against the various forms of risk:
Annuity vs Stock vs Types of Investment Risk
Market risk receives the most attention especially during turbulent markets. When stock prices decline in value, there is a risk of loss of principal. With that risk, however, comes the potential for gain. The problem is that is impossible to know which way the market will move. Fixed annuities have no market risk, and, as such, they have limited upside potential. For people who are adverse to market risk the advantage goes to annuities.
Over time, inflation can have the same effect on your capital as market risk. If you are investing in low or fixed yield investments there is a chance that the growth of your capital may underperform inflation which means your capital won’t be worth as much in the future. This should be a concern for pre-retirees who can be expected to live another twenty-five years. Stocks have always been a go-to investment for people concerned about their capital outpacing inflation. For people who fear the wrath of inflation on their ability to fund a long-term retirement, the advantage goes to stocks.
Interest Rate Risk
Any investment that is tied to the movement of interest rates is at risk of losing either capital in the case of marketable bonds, or opportunity in the case of a fixed rate investment, such as fixed annuities, where the interest rate can be adjusted downward. Stocks are also interest rate sensitive in that they tend to perform better in low interest rate cycles because they become a more attractive alternative than bonds or fixed yield investments. If interest rates rise, annuities can perform better as long as higher rates can be obtained. For people concerned about the direction of interest rates, there is no clear advantage between stocks and annuities.
One of the primary reasons people turn to annuities is because of their tax advantages. Very few investment alternatives can match the annuity benefits of tax deferred accumulation and partially taxed income at annuitization. Stocks enjoy some tax benefits in that their gains are taxed at a lower capital gains rate and their losses are deductible to a certain extent. Investors in actively traded stock portfolios, including many mutual funds, incur taxation anytime stocks are sold for a gain which affects their net return. For people who abhor taxes the advantage is with annuities.
One of the main criticisms of annuities is that they are considered to be long-term, therefore, illiquid investments. While it is true that the best use of annuities is for their long term accumulation and guaranteed income benefits, deferred annuities do allow for limited access to funds without charges. There are tax consequences associated with annuity withdrawals but there is also liquidity. Stocks are considered liquid to the extent that they are marketable and can be redeemed for cash at any time. The problem is that people are reluctant to sell their stocks if they are in a losing position. To that extent, stocks have liquidity issues as well. For people who are most concerned with having access to their capital, there is no clear advantage.
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The Final Analysis
The objective for any investor should be to find ways to control or reduce the amount of risk they take while investing their money in pursuit of their specific objectives. Most financial planners will advise against putting all of your eggs in one basket because that is the way to expose your assets to the greatest amount of risk. By spreading investment dollars among different types of assets the risks that are associated with any one type are mitigated and balanced with another.
Another key is to maintain a long term horizon for your assets at work. Both annuities and stocks can perform well given the appropriate amount of time. Investment, economic and interest cycles are inevitable and self-completing which allows most investments to achieve expected results over time.
The ideal portfolio for most investors is comprised of investments that complement each other during competing and opposing cycles. Annuities will always provide protection against market and taxation risk, and stock will be a better guard against inflation, so some combination of both can be the best way to control and lower all risk.
Go Long: Investments, especially those with exposure to market risk, interest rate risk or inflation risk, should be consider as long-term commitments in order to allow them to ride through the inevitable economic and market cycles.
Establish a liquidity fund: By creating a secure, cash fund with sufficient monies to provide for short-term or emergency needs, one can afford to ride out market downturns.
Invest with Quality: By limiting your investment choices to companies that have demonstrative financial strength, you can reduce the risk of default or market loss due to a failed enterprise. While the stock of quality companies is always vulnerable to market downturns, the likelihood of them failing all together is less than with companies in questionable financial condition.
Investing for the reward of a return on an investment should always be considered along with the risk that is commensurate with that reward. The key is to know your tolerance level for risk and weigh it against your needs and priorities to determine if you are able to remain within your comfort zone. If you determine that, in order to be able to meet your most important needs, a higher investment return is required, apply as many risk reduction methods as you can so as to minimize your overall risk.
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