Photo by Ophélie Authier | Unsplash
By Jeremiah Williamson CFP and Kevin Dykes
Imagine if you’d bought Facebook at its IPO. Or Amazon. Where would you be right now? Retired on a beach in Maui? Driving a Ferrari? Living in San Francisco? In the paraphrased words of Dr. Seuss: Oh, the places we could be if we’d only bought the right stock at the right time.
Ah, but what about human nature. If you’d bought Facebook at its IPO price of $38, you’d be up 600% (as of 2/5/21). Depending on how much you’d invested, you could have created a decent nest egg for yourself off of that IPO alone. But first, you’d need to have held on through a 50% decline in the first year of trading. If you had invested enough to make a significant difference in your retirement security, what would you have done seeing half your wealth melt away? In our opinion, some other IPOs have been less dramatic. Amazon, for instance, never plummeted as Facebook’s stock did, but it also took over a decade before it began to take off. What seems like a no-brainer hindsight is no sure thing in the moment.
There’s a lot of allure in chasing returns and the next “hot stock,” but the reality is seldom as shiny as the idea. Sure, you could make over 200,000% on a good pick like Amazon, but you’d need to have patience and foresight for decades to realize that gain. What if while you were waiting for your IPO investment to turn into a golden egg, you were in a car accident and couldn’t work? Or worse: What if you passed away? What would your family do for income without you?
In our experience, too many investors are focused on portfolio returns and overlook the importance of risk management. You may think you’re young and healthy, but betting on your indestructibility is not a protection strategy. According to data by the Social Security Administration, nearly one in four workers entering the workforce today will become disabled before reaching their full retirement age. Do you really want to bet your and your family’s future on odds like that?
The Importance of Risk Management Risk management is a foundational part of any good financial plan. Just like your house, if your financial plan doesn’t have a good foundation, a bout of bad weather could blow the whole thing down. Without adequate protection, your investments will be exposed to the elements and are less likely to get the time they need to grow into the nest egg you want.
When we meet with clients for the first time, we always start by checking that they have enough cash on hand. You need an emergency fund that can cover immediate unexpected expenses. The amount of cash you need will depend on your lifestyle and income security. Someone in a more stable job who has fewer expenses will need less than someone in the opposite situation.
After verifying a client’s cash reserves are well established, the next thing we look at is insurance. There are many different forms of risk management, from investing strategies to income protection vehicles. The right strategy for you will evolve as your wealth grows and income needs change, but a good starting point for most can be disability insurance and life insurance.
Disability Insurance The first place most would turn if an accident left them unable to work would be workplace disability insurance. In our opinion, these policies are seldom enough. Typically employers provide only short-term disability insurance, which lasts for less than one year (usually three to six months). Long-term disability insurance can cover years or even decades, but fewer employers offer it. It usually only replaces 40-60% of your income, causing what we refer to as the “disability income gap.” This gap may be particularly detrimental when bonuses or commissions account for a significant portion of your pay.
With less income in a time when your expenses are likely higher than ever thanks to the cost of medical care, you might need to sell some of your investments to cover the shortfall. You might even need to sell that treasured IPO.
There’s also a “Disability Disconnect” that many people aren’t unaware of. Most of us believe our odds of becoming disabled and missing work for at least three months is only 1%. The reality is that more than 25% of today’s 20-year-olds will become disabled before they retire, according to the Social Security Administration. This means that you are far more susceptible to the disability income gap discussed above than you might believe.
One way to reduce this disability income gap is through an individual disability income insurance policy. A financial professional can help you assess what makes sense for your individual situation.
Life Insurance The next element of a strong financial foundation is making sure you have adequate life insurance coverage. Before you say you’re too young for life insurance, consider that there’s over an 11% chance someone born in or after 1966 will die before reaching full retirement age. Remember that when you choose not to get life insurance, it isn’t your life you’re gambling on; it’s your family’s. If someone other than you relies on your income, you should probably have life
insurance. You can cover a specific period of time with term life insurance or your entire life with whole life insurance. These policies provide income for your loved ones in the event of your death, but each does so in a slightly different way.
Term Life Insurance Term insurance is the simplest form of life insurance and the one many people start with. It provides a death benefit to your beneficiaries if you die during a specified time, usually 10 to 30 years, provided you keep paying your premiums. You can lock in a lower rate by buying term life insurance when you’re young. If you wait, premiums only increase as you age. The death benefit is a predetermined amount paid to your beneficiaries. It can be paid as a lump sum or in different ways (like a monthly payment), depending on the issuing company's payment options. If you die outside of the term window or stop making premium payments, there is no death benefit.
Whole Life Insurance Unlike term life insurance, whole life insurance provides a death benefit no matter when you die, provided you stay current on your premium payments. These payments typically stay the same throughout your life, so you don’t have to worry about the cost of coverage increasing as you age.
Over time, whole life insurance builds up a cash value, which can be withdrawn or taken as a loan. Withdrawals and loans may reduce the policy’s death benefit and could have tax implications. There are some other important considerations as well. Whole life policies can cost five to 15 times as much as comparable term life policies. Also, whole life policies take a few years to start accumulating cash value. If you decide to surrender the policy early, you may end up with the equivalent of a costly term policy. When considering a whole life policy, it’s important to understand that it takes time to reap the rewards of ownership.
You Never Regret Having the Protection You Need Many investors focus on portfolio returns while overlooking the importance of risk management. Taking steps to help protect your income through the right types of insurance is the moat around your financial castle. It helps protect your other assets from external threats. From experience, we can say that in the few times we’ve had to deliver a death or disability benefit to a client’s family, it is always gratefully received.