Much has been written about disability insurance. This blog post, instead of discussing the merits of disability insurance in general, will focus on one concept that could potentially save you 30%-40% in premium costs annually – the elimination period. The elimination period is the amount of time, after sustaining a disability, that someone must wait before the insurance company begins payments. Auto and home insurance have deductibles before they start paying out claims. Disability insurance (and long-term care insurance) has elimination periods before paying out claims.
One of the most common elimination periods is 90 days. Because insurance companies are more likely to make payouts with a 90-day policy, the costs are much higher. For those who can easily afford the higher payments and who want to minimize the risk to a very low level, this could be a good decision. But for most of us, this is not the best way to think about insurance. We believe that insurance should protect you from catastrophic risks. Self-insurance for smaller claims is often the more efficient way of handling those risks.
In many cases, the true risk to a long-term financial plan is not one year of lost income. It is 5, 10, 20+ years of lost income. Let’s take someone with a 10 year disability. He/she would receive 9 years of payments with a 1 year elimination period and 9.75 years of payments with a 90-day elimination. In essence, this person receives over 92% of the benefits (9 years divided by 9.75) while likely paying only 60-70% of the premium (of what a traditional 90-day elimination period policy would cost). Of course, you have to be willing to forgo benefits if you experience a shorter-term disability (lasting less than 1 year). This is accomplished by keeping an adequate reserve fund (cash or highly liquid safer investments) available to cover one year of expenses should you become disabled. By utilizing a longer elimination period, individuals can protect against devastating losses, while keeping their ongoing premiums affordable.
As always, individual situations and policies vary so it’s best to speak with someone objective about these issues. Insurance agents, many of whom are compensated with a commission based on the cost, often do not highlight these longer elimination periods. So make sure to ask questions, get the facts, and make the best decision for you and your family!
"The riskiest moment is when you are right"- Peter Bernstein
When I started in this business it was near the peak of the tech boom. It seemed like a great time to get into the financial advisory business. Employment was booming, people were speculating on stocks, and everyone seemed excited about the markets. We all know what happened next. The stock market tanked and all of the highest fliers crashed and burned. As an advisor, nothing seemed to work. A new client would come on board and within a few months their assets were worth less than what they had started with. Remember, this bear market was long. It started in 2000 and didn't hit bottom until mid-2002. When it was finished, over 50% of the value of the S&P 500 had vanished. I have always said that this experience was a defining moment for me and my clients for two reasons:
- It made me realize how important diversification was. Not just diversification amongst stocks, but all asset classes. While large US stocks were crushed during that period, other asset classes like small cap, value, emerging markets, real estate and bonds, were all positive. What you give up during a bull market by being diversified is much smaller than what you gain when the market falls.
- It made me realize how little I knew. When you understand how many smart people are competing against you in the market and how difficult it is to beat them, you take an entirely different approach to investing.
An article in the WSJ points this out beautifully:
But in the financial markets, where so many investors are highly skilled, their actions cancel each other out as they quickly bid up the prices of any bargains—paradoxically making luck the main factor that distinguishes one investor from another.
And a streak of being right can make anyone forget how important luck is in determining the outcome.
Research led by psychologist Ellen Langer, now at Harvard University, shows that when people who predict the tosses of a coin are told they got eight out of their first 10 flips correct, they conclude that they are significantly better than average at calling heads or tails—and that they could get well over half their guesses right if the coin were tossed another 100 times.
Prof. Langer called these incorrect beliefs “the illusion of control.”
If, however, people either get most of their early guesses wrong or win and lose in a random pattern, they don’t believe they have any special gift for calling heads or tails; nor do they remember being correct more often than they were.
Many of my friends who started advising clients several years before I did never recovered from the tech crash. You see, they were right for years, and they started to believe in their own ability. Unfortunately, they place their belief in something that couldn't be sustained…their own skill. For me, I failed from the very beginning. I learned, I had no special skill when it came to picking the best stock. I also came to realize that no one else had this skill either. That it was luck masquerading as talent. This experience shaped my beliefs when it came to investing. Betting on an individual's skill was a dangerous game. I came to realize that I would rather focus on things I had control over like diversification, tax minimization, costs and discipline. It's funny that it took failure early on my career to figure out the recipe to successful investing.
In the first three posts of this series we discussed three ways investors can maximize their returns- rebalancing, portfolio construction, and exposure to specific risk factors. In the final three posts, we are going to discuss three focal points to limit the amount that they lose to areas under their control. Specifically, taxes, costs and behavior. Behavior is probably the area that has the largest potential for losses. Investing is an emotional battle for many of us. As humans we are flawed individuals. Take for example some normal biases that most of us have:
- We believe we are smarter than we are.
- We remember our winning investments much more than our losers.
- We tend to believe what has happened in the immediate past is most likely going to happen again.
- We focus on data that confirms our original opinion and ignore other data that contradicts our viewpoints.
- We are loss averse, feeling more pain when we lose $100 than enjoyment when we gain $100
- We prefer stories over data to explain our current reality
All of these biases show up in investor returns. Morningstar measures investor returns (the returns investors actually receive) versus fund returns (the actual returns of the funds). They are different numbers because investor returns factor in fund flows. What they have found is that investor returns trail fund returns because investors tend to invest or withdraw money at the wrong time.
For an average investor, it seems as if behavior accounts for approximately 1-2% of the "Gap" each year. So, what can we do about it?
The main culprit driving poor performance when it comes to behavior is emotions. Investors tend to get excited AFTER investments have gone up in value (resulting in buys) and scared AFTER investments have gone down (resulting in sales). Anything you can do to avoid emotional reactions is crucial. Here are a few tools we use with clients:
- Use an objective third party for advice- sometimes it is hard to know if our decisions are appropriate or if we are letting our emotions get the best of us. Getting advice from someone who knows your situation, cares about you, but is also not as emotionally invested can be extremely helpful. That is why we believe an objective, thoughtful advisor can be extremely beneficial when it comes to behavior.
- Create an Investment Policy- if you have a written guideline of how much you are going to invest in stocks, bonds, cash, etc. and you follow it, it is much more difficult to get off track behaviorally. For example, if you have an allocation of 70% to stocks and they have a great year, your portfolio may now be at 80% stocks (overweight). Your investment policy would tell you to sell stocks in order to bring it back into balance. Emotions may tell you different, but if you follow this policy, you are taking emotions out of the decision making process.
- Automate where you can- automatic investment programs (like 401ks) and automatic rebalancing puts things on auto pilot and creates less chance for human error.
- Demand data- never buy an investment that has a good "story" without data. Demand to see the data behind it and make sure that there is a logical reason why it is a good investment. Variable annuities are a great example of this. I have heard the "pitch" a hundred times. You get the return of the market or a guaranteed return of 6%, whichever is greater. This is a great story, but once you dig into the data you find it to be very misleading.
Controlling behavioral biases is a huge factor in "shrinking the gap". In our last two posts in this series we'll be taking a look at two other areas that can widen "the gap".
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.