As anyone would have expected, the extraordinary convergence of extreme stock market volatility, low interest rates, declining home values, diminished retirement savings accounts, and chronic economic sluggishness has taken a severe toll on the American psyche. For many investors, it may have forever altered the way in which risk is perceived and managed.
Understanding your risk tolerance is one of the most important elements of investing; knowing how your risk tolerance effects your investment decisions is vital to the health of your portfolio.

Risk tolerance is most prevalently understood as a measure of one’s financial ability to withstand losses. On the risk-reward continuum, the more risk one takes, the greater the reward should be expected, and vice versa. For example, an investor who can withstand a 25 percent loss in his portfolio value without it affecting his ability to meet his long-term goals may be able to invest more aggressively in order to achieve potentially higher returns than someone who couldn’t afford to lose more than 10 percent. The financial measure of risk tolerance is a function of several factors including time horizon, income, liquidity, and net worth. Generally, the more of each an investor has the more risk he may be able to assume because of the greater capacity to recoup losses.

Know Your Emotional Risk Tolerance

Less understood is the emotional component of risk tolerance, yet it can have far more influence over investment decisions than the financial ability component. Emotions are far more powerful than logic and can drive investors to make decisions without regard for their financial ability. The two emotions that can be the most devastating to investors are fear and exuberance, and both can be triggered through the irrational behavior of a reactionary crowd. It’s what can lead investors to flee the stock market in masse after it has already fallen by 15 percent; and it’s what can draw investors into a raging market rally near its peak. In either case, investor risk tolerance is skewed by emotions which often results in investment decisions that bear no reflection of their long-term investment strategy.

Still, emotions are an important element in risk tolerance when they are understood. Fear breeds caution which is never a bad thing in investing. But realizing that emotions are reactionary mechanisms that tend to drive decisions based on short term events, may help investors keep them in check when viewed in the context of a long-term investment strategy. It would be hard not to lose some sleep when the stock market experiences a flash crash of a 1000 points. You wouldn’t be human if you didn’t. However, realizing that, the only people affected by such a crash are the ones who actually sell their stocks, might help to keep a short-term event – positive or negative – in perspective.

Generally, investors who tend to focus primarily on the markets might experience a roller coaster of emotions. As a consequence, their confidence is more inextricably tied to the performance of the market. Conversely, investors who stay focused on their long-term investment strategy need only to have confidence in the strategy. If it’s well-conceived with optimum diversification and well-managed through proper rebalancing and adjustments for an evolving risk tolerance, they can be more secure in their confidence.

One of the principal tenets of investing is that no one single investment is right for everyone. Every investment has certain characteristics, risks, and objectives that must match those of the investor, and fixed annuities are no different. Although fixed annuities have become more popular in light of the recent financial turmoil and the carnage it has left behind in retirement accounts, investors should still take care in considering whether they are best suited for them.

As economic uncertainty increases, concerns over financial security mounts causing people to look for alternatives that provide more guarantees and predictability. Currently, more than 50% of pre-retirees fear that their assets won’t generate the income they need for their lifetime. Because fixed annuities protect principle while providing a guaranteed income that can’t be outlived, investors are looking to them for at least a portion of their retirement portfolio.

Before expending the time and effort exploring specific fixed annuity products, you should assess your own situation to determine if the benefits of fixed annuities can meet your particular needs. Here are five questions you should ask regarding their situation before considering fixed annuities:

Am I contributing the maximum amount to my retirement account?

Fixed annuities do offer the advantage of deferring taxes on earnings until they are received, just as qualified retirement plans, however, contributions to fixed annuities are not tax deductible. As a general rule, you should take every advantage of using you before tax dollars to save for retirement before considering other investments. It is possible to invest in fixed annuity within your qualified plan. Although you wouldn’t benefit from the tax deferral of a fixed annuity inside your plan, it can add stability to your portfolio and produce a guaranteed stream of income at retirement.

If your income is subject to taxes in the higher brackets, you stand to benefit more from the tax deferral of fixed annuities. The deferral of taxes is important because it helps offset the fees and expenses associated with fixed annuities and it enables your money to compound faster. Investors in lower brackets wouldn’t realize the same amount of benefits as investors in higher brackets, so they may be better off in taxable investments.

How much time before I need the money?

An investment in a fixed annuity is for the long term. Although fixed annuities allow access to your funds, the early withdrawal penalties limit your access to 10% of your balance per year. There are also IRS penalties for withdrawals made prior to 59 ½. More to the point, fixed annuities work best when they are left to work so that the tax deferred compounding can work its full magic. Unless your timeframe is such where you can hold the fixed annuity for at least 15 years, it may not be right for you.

Do I have enough cash?

If your investment funds are committed to long-term or illiquid assets, you need to ensure that you have enough liquid assets in the event that your circumstances require them. This is especially important after you have retired. Once a fixed annuity is annuitized (converted to a stream of income), your capital is committed to the insurer. It’s always advisable to have at least six to nine months of living expenses set aside in a liquid savings account.

Do I lie awake wondering if I will run out of money in retirement?

Most studies done on the subject indicate that an alarming number of Baby Boomers will fall short of their income needs during retirement, which means they will need to delay retirement or drastically cut back on their life style expectations. Life expectancies are expanding in the face of economic uncertainty and that is enough to keep most people up at night. Fixed annuities are the only vehicle that can provide a secure, predictable flow of income coming for as long as you live.

Am I getting anxious about losing anymore of my principal investment?

There’s no question that the financial markets have people on edge about the safety of their principal. The last few years has seen record outflows from stock mutual funds in to cash and other secure investments. While it is always advised to have some exposure to the stock market as a hedge against inflation over the long term, physicians need to balance the volatile side of their portfolio with more stable or fixed investments. As the retirement time horizon shortens, physicians are advised to reduce their exposure to risk. Fixed annuities, with their record of safety and their guarantees, certainly could comprise a portion of the low risk side of the portfolio.

The final analysis

If your assessment produced more than one affirmative answer then you may be a candidate for a fixed annuity and it would be worth exploring the different types that are available. Fixed annuities are complex instruments and they include many features that need to be fully understood. And, because they are a long term investment, it is important to go into a fixed annuity investment with eyes wide open. If it is determined that a fixed annuity is right for you, they be one of the best investment you can make.