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Market Risks

Participation in the financial markets and capturing market returns, is an important part of most people’s investment strategy.  Financial markets, however, are volatile, with the trend showing perhaps even more volatility in the future.  Extreme volatility can cause investor anxiety, as well as negatively impacting future asset values and cash flow.

The common technique employed to address market volatility and losses is Asset Class Diversification.  Unfortunately it provides only a partial solution as risks generally fall into one of two categories; 1) diversifiable risk, and 2) un-diversifiable systematic risk, which can’t be diversified away by Asset Class Diversification.

Diversifiable Risk

Diversifiable risk is inherent within a specific company, industry, or asset class.  A poor earnings report, a detrimental headline, or an investment rating downgrade represent a few examples of diversifiable risks.  This type of risk can generally be diversified away through appropriate asset class diversification.

Systematic Risk

Systematic risk, on the other hand, is inherent to the entire market or market segment, and can affect the whole “system”.  Examples of systematic risk include global economic crisis, large interest rate movements, recessions, and asset bubbles, to name a few.  They can have a significant negative impact on asset values if they occur.  Systematic risk cannot be diversified away by asset class diversification, and is best addressed by Hedging.

Un-diversifiable systematic risk is responsible for some of the largest upswings in asset volatility on record (e.g., ’73-’74, ’00-’02, ’08-’09).  For example, during the most recent financial crisis, nearly every major asset class declined in lockstep (save U.S. corporate bonds).  While systematic risk may have a low probably of occurrence, with 2 major shocks in the last 17 years, there is evidence that the probability is higher today than in the past.

The Total Solution

The most effective asset allocation should address both diversifiable risk and un-diversifiable systematic risk.  Diversifiable risk can be addressed by Asset Class diversification, and Equity Indexing provides an alternative strategy for capturing market returns, while also addressing un-diversifiable systematic risk.  Various factors will determine how much is allocated to each.

Asset Class Diversification

Based on Modern Portfolio Theory, Asset Class Diversification refers to the optimal mix of stocks bonds and cash that provides the greatest return potential consistent with investor risk tolerance.  Risk tolerance takes into account investor time horizon, and comfort with market volatility and losses.  The process generally includes money manager evaluation, selection, monitoring, and reporting.

The success of this technique is measured in relative terms, against a benchmark, rather than in absolute terms. In down years, as an example, success is measured by being down less than the benchmark.

Equity Indexing

Equity Indexing provides an alternative approach to capturing stock market returns, while also addressing un-diversifiable systematic risk.  A method to determine how cash value grows within an Accumulation Designed Life Insurance policy, equity indexing allows the policy owner to participate indirectly in the upward movement of a stock index without actually being in the market, while also eliminating the risk of market losses. (Hedging Strategy).

The success of this technique is measured in absolute terms.  In years where the underlying equity index increases, the policy cash value is increased based on the crediting formula.  In years where the underlying equity index is flat or loses value, the cash value is subject to a floor which guaranties against any loss in value.

Putting It All Together

Asset Class Diversification is a valuable technique to address diversifiable market Risk.  Equity Indexing provides an alternative technique for capturing market returns, while also addressing un-diversifiable Systematic Risk.  The appropriate allocation to each is based upon several factors, including individual facts and circumstances as well as individual views on market risk.

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