Bringing Wall Street to Main StreetThis content is categorized as:
The large investing organizations that operate on Wall Street — in other words, institutional investors — have long had access to sophisticated strategies involving state-of-the-art computer programming to manage their portfolios. These programs use preset procedures to shift the allocation of assets in portfolios instead of relying on human decision-making.
Main Street investors today can also benefit from this rules-based, or algorithmic, approach. For those seeking the protection an annuity provides while being able to participate in market growth, custom index options inside a fixed indexed annuity (FIA) can reduce volatility and increase stability. Retirees who value stability and growth potential within their retirement plan might find these custom indices in FIAs particularly helpful.
How volatility affects your investments
Volatility is how much and how quickly prices of assets change. Price movements during periods of volatility can be unpredictable and large, increasing the risk in an investment.
Uncertain market conditions are a frequent cause of volatility. For example, think of what happened to the U.S. stock market in early 2020 because of COVID-19. After peaking on Feb. 19, the S&P 500® (an index comprising the 500 largest U.S. companies that’s widely used to represent the market as a whole) plummeted 34 percent by March 23.
Over the long term, there’s usually a tradeoff between volatility and return. Despite the volatility in 2020, for example, stocks historically have provided a better return over the long term than lower-volatility investments such as bonds.
But for someone seeking more stability while participating in market growth, traditional investment options alone may not deliver on those goals. On a 10-year time scale the rolling annualized returns for the S&P 500® have varied significantly — from a loss of 6.2 percent to a gain of 17.2 percent. This wide range in returns can pose a challenge to those seeking to retire with more stability in their investments.
That’s where a FIA with custom indices can help offer smoother returns through a rules-based approach to help control risk.
Step by step with risk control
Let’s walk through an example of how this works in a hypothetical custom index that tracks the S&P 500®:
- There are two components to the index: one is a basket of stocks, in this case based on the S&P 500®, and the other is a low-risk asset — for this example, cash.
- A target level for volatility of the underlying index is determined. In this case, let’s say 8 percent. That level is about half the long-term volatility of the S&P 500®, which is 15 percent.
- The volatility control mechanism then tracks the volatility of the S&P 500®. When the volatility increases:
- The mechanism automatically reduces exposure to the underlying index.
- The mechanism automatically increases exposure to cash.
- As a result, less is now aligned to the relatively high-risk asset — the S&P 500® index fund — and the portfolio is more aligned to the low-risk asset (cash).
- The mechanism changes the allocation from the S&P 500® index fund to cash to maintain an overall volatility level of 8 percent.
- When volatility decreases, the opposite activity occurs: The exposure to the S&P 500® index fund is increased, and the exposure to cash in the portfolio decreases. This maintains the 8 percent volatility level.
Reducing the shock from the pandemic
This rules-based approach can help smooth returns and limit ups and downs when the market is volatile. For example, when COVID-19 crippled the economy the S&P 500® plummeted almost 34 percent, while custom indices on average fell only 11.5 percent.
As part of a diversified portfolio, FIAs with custom indices can provide a more predictable path for you to meet your goals. Their rules-based approach provides an automated buffer against the volatility of down markets, while still allowing you to participate in what historically has been the long-term growth of markets.
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