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Rule of 100

A Tool Developed by Financial Professionalsto Limit Stock Market Risk

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By Paul Bullock CLU ChFC GBA RPA FLMI CEBSPublished by Capital Strategies Press / Sponsored by MarketLinking.com

http://marketlinking.com/


Rule of 100 & 110Every financial professional knows that the chance of sudden and unexpected loss is part and parcel to stock market investing. As a result, the rule of 100 has come into general use. The rule of 100 simply states that the percentage of funds committed to the stock market should not exceed the age of the investor subtracted from 100.

% of Funds in Stock Market = 100 – Age of InvestorAge Rule 100 Rule 110 20 80% 90% 40 60% 70% 50 50% 60% 60 40% 50% 70 30% 40% 80 20% 30%

Both rules are useful guides, but they are a sign that buying stocks, either individually or in a managed portfolio, is risky and consumers should take steps to manage that risk.

The Stock Market is Always AdjustingThe graph shows the annual price changes of the S&P 500 Common Stock Index, which is often said to mimic the performance of the entire stock market. Annual price changes are measured month-end to month-end one year later and includes every month-end from Jan 1970 to Dec 2012 (504 one year periods). Historically, the market has yielded substantial gains as well as generated significant losses.


Losses are Guaranteed - if You Stay in the Market Long Enough

Our study of stock market stability over one year periods showed mixed results. In some years the market delivered huge gains, in others ruinous losses. The market was up 73% of the time, but lost money 26% of the periods and broke even twice. The average gain was 8.25% and the highest gain was 53.37%. However, the biggest loss was 44.76%, almost half of the portfolio.

Loss of a years savings is inconsequential, the true threat from the stock market is the loss of a large chunk of the retirement nest egg. Retirement funds are built up over time in small increments. Annual stock market gains are added to these increments and interest begins to compound, multiplying your savings. Because that savings is continually in the stock market, the chance of hitting a down year, becomes almost certain. A market downturn, not only creates a loss for that year, but wipes out years of accumulations in one swipe.

Therefore, techniques like the rule of 100 were developed to bleed money out of the stock market over time and flow those funds into safer, but lower yielding alternatives.

504 one year periods, from Jan1970 to Dec 2012 were measured from month-end to month-end twelve months later. This represents a statistical sample of about 4.6% of the potentially 10,920 one year periods if measured from each business day to the same business day one year later. Only the changes in stock prices were analyzed. Dividends were ignored in the study which were 1% to 3% during the period and would therefore increase the average yield and mitigate the gains and losses.


The rule of 100 reduces stock market risk by balancing the portfolio (replacing some of the stocks with bonds). Bonds, like stocks, are sold in the public markets. This makes them subject to unpredictable changes in price, very much like stocks. However, since bonds are ultimately redeemable for their face value,

25% Stocks

75% Bonds

75% Stocks

25% Bonds

well chosen bonds can inject a high degree of stability into a mixed portfolio. On the downside, bonds historically pay a lower rate of return than common stocks, therefore, adding bonds to the portfolio will lower the overall return of the holdings.

Balanced Portfolios


What Can You Expect From Bonds Return?

A study of bond yields for the 92 years shows considerable fluctuations, but also a long term trading range. (These are the quality of bonds that government regulators normally allow insurance companies to purchase.)


Balanced Portfolio Using Rule of 100

Age % in Stocks % in BondsPortfolio Yield

(Stocks 10% / Bonds 6%)

30 70% 30% 8.82%

35 65% 35% 8.62%

40 60% 40% 8.42%

45 55% 45% 8.22%

50 50% 50% 8.03%

55 45% 55% 7.83%

60 40% 60% 7.63%

The above table shows the returns from balancing a portfolio in accordance with the Rule of 100. As the percentage of bonds increases, the total yield is reduced, hopefully, in exchange for lower volatility in the portfolio. However, the returns above are expected average returns. As we have seen, the actual annual return results can be unpredictable to say the least.


Bond Economics Bond Annual Bond Price at Coupon Interest -------- Market Interest Rate --------- Rate Paid 2.5% 5.0% 7.5% 2.5% $25 $1,000 $1,500 $3,000 5.0% $50 $2,000 $1,000 $ 667 7.5% $75 $3,000 $ 500 $ 333

The table shows the price fluctuations of a $1,000 bond as interest rates changes. We pretended that the bond is perpetual, which allow us to ignore the price support effects of the bonds eventual pay-off.

WOW! The bond market looks as dangerous as the stock market. A 2.5% increase in interest rates can drop a $1,000 bond to $500. Of course, the price could also rise to $1,500 if interest rates fall.

Note: These numbers are a little exaggerated, because bond prices are ultimately supported by their surrender value. Therefore, a 5 year maturity would respond much less to an interest rate change, than a 30 year bond, because the pay-off date is much closer. The above prices ignore these kinds of price supports and are shown solely to illustrate why bonds prices are volatile.


Stock & Bond Combined Volatility

Balance portfolio are used to reduce market volatility and the chances of a large loss in the market place. However, this technique is not 100% effective. As we have seen, both bonds and stocks can under go substantial prices change in a relatively short period. These price swings can not be predicted and can be substantial. Limiting bond holdings to ten your maturities does dampen the possibility of loss and somewhat stabilize the overall portfolio, but this is only a partial safeguard.

Part of theory of a mixed portfolio is that both stocks and bond prices will not move in the same directions. Therefore, volatility in one, will be offset by opposing volatility in the other. The graph above overlays annual changes in the bond and stock market. In some years they cancel one another out. However, in many situations, they both stress a mixed portfolio in the same direction.


To Summarize - a Balanced Portfolio• Has lower overall market risk

• Has lowers total return

• Has lower expected return, but a more reliable projection of return

• Still contains risk, because both the stock and bond components can move to reduce portfolio values


Bonds are Not the Only Source of Stability

If market linking CD’s and indexing life and annuity policies can provide yields in excess of bonds, plus complete protection from market downturns, why not use it as an alternative in our Rule of 100 planning?


The returns and price volatility discussed and projected herein are taken from historical studies of commercial bonds and common stocks in US financial markets. However, there are alternative portfolio management techniques that dampen portfolio volatility and protect against market losses using an entirely different approach.

Market liking, also termed indexing, places the entire portfolio in bonds and uses the interest from the portfolio to hedge a stock market index or other asset index. When the asset index rises, the earnings are credited as interest. If the price of the asset index falls, the loss is limited to the annual interest used to purchase the market hedge. Market linked portfolios can be designed to rely entirely on asset price increases or to provide a minimum annual interest that is augmented with asset prices rise.

Indexing and market linking is a way to participate in stock market gains without the risk of market losses. Indexed savers are essentially trading some of the market gains, in exchange for total protection from all market losses. Market linked CDs are issued by banks and the accounts qualify for FDIC insurance. Insurance companies issue indexed annuities and universal life policies and guarantee the principal of the policyholders.


For additional information on market linked and/or indexed product please visit:

MarketLinking.com

PolicyChallenge.com

These websites contain hundreds of pages of information, insights, comparisons, historical data, buying tips and financial planning concepts. Please educate yourself about these unique products.

http://marketlinking.com/

http://policychallenge.com/

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Economy & Finance