Make Money In Stocks

Knowing the difference between a fixed and a variable annuity can be what protects you from financial loss and buyer’s remorse. Those two types of annuity form part of an annuity matrix. The other dimension of the annuity matrix would be ‘immediate vs. deferred’ annuities.

Variable annuities were developed to overcome the shortcomings of the fixed versions. Fixed annuity contracts are income-oriented while variable annuity contracts aim to provide growth opportunities to annuitants. This inherent difference precipitates other differences between the two forms of annuity.

1) Accumulation rate determination

Fixed annuities can either use a stock-index or declared interest to determine what rate of accumulation. The stock (or equity index) has a value that is computed as a fraction of the stock’s overall value. That is a particular form of fixed-annuity incorporates an aspect of the variable annuity – hence, it is perceived as a hybrid.

Declared interest or market-value-adjusted annuity offers a rate that is linked to market performance overall, but is stable and steady. This type is therefore based on the general level of market rates. For this reason, a middle ground that is easily achievable is selected. That is why FAs of this nature hardly fluctuate.

VAs operate in a similar manner to mutual funds. The pool of funds is created by the annuitants who contribute towards the pool of funds. The term ‘interest rates’ is not applicable to such financial instruments. However, the ‘rate of return’ concept is. In some instances, annuitants are provided with fund options and can manage the level of risk they take. However, the rate of return with VAs is primarily determined by the investment performance net of expenses.

2) Expenses/ fees

VAs have expenses and fees associated with fund management and investment returns. These expenses would be in addition to those stipulated by the typical contract. FAs would have fees and charges associated only with the annuity concept. Still, some FAs bear no expenses associated with the annuity contract after a specified period. VAs would always be loaded with fees and expenses, that might even be hidden.

3) Payout phase

Annuities have a payout phase – where payments are disbursed according to myriad factors. The FA has a constant rate in the payout phase that is based on the prevailing market conditions or actuarial considerations. VAs can provide either fixed or variable payouts. The latter are based on the annuity provider’s fund performance as well.

4) Exposure and risk

Annuities might bear guarantees on contributions and returns. By extension, FAs are significantly less-risky than variable ones. A fixed annuity also provides better guarantees than a variable annuity; thereby increasing the security and stability of FAs in comparison to variable ones.

The discrepancy between the two types of annuities is vast. It even extends to the fact that variable annuities are more heavily regulated. They fall under the purview of the Securities and Exchange Commission (SEC) (as well as the relevant insurance regulators). That underscores the fact that the VA is somewhat removed from the FA. In most cases, fixed annuities are actually considered to be superior to variable annuities.

Proponents of market efficiency divide risk into unsystematic and systematic. Unsystematic risk is not priced by everyone investing in the stock market. Here is an example to help you understand unsystematic risk. If you are considering investing in the stock market you could either buy specific stock in a specific company that you think will have a rise in price in the future. On the other hand if you don’t trust your stock ability you have the alternative of buying a basket of stocks that mimics the stock markets total combined movement. One way would to be to buy an indexed mutual fund like VFINX which is pegged to the S&P 500 which is a very large stock market index. The degree to which the stock moves relative to the general market is the unsystematic risk of the stock.

Systematic risk is the degree to which the stock changes in price relative to the general stock market as measured by an index like the S&P 500. Model calls this measure a stocks “beta.” The Fama-French Three Factor Model is a regression analysis that tries to separate out the systematic risk of a stock from the unsystematic risk by compensating for three factors. The first factor is a financial ratio called book to market. The second factor is the size of the firm as measured by its market capitalization. The third factor is the return on the market portfolio.

The book to market ratio is nothing more than what accountants estimate the company to by worth divided by the market capitalization of the company. The market capitalization of the company is the share price of the stock times the total number of shares the company has outstanding in the stock market. The return on the market portfolio is measured by some index like the S&P 500.

According to the efficient market school (which I do not agree with), size and book to market reflect systematic risk, meaning risk that requires compensation in the form of higher expected returns. If this is the case researchers should see that investors perceive small-value stocks to be riskier than large-growth stocks. The do see this which does lend some support to market efficiency. But investors consistently expect large-value stocks to outperform small-growth stocks and this is perverse. Basically, investors recognize that small upcoming companies are riskier but do not expect to be compensated for this risk as the efficient market model says that they should.

In a similar fashion, analysts tend to recommend growth stocks more favorably than they do value stocks. In the efficient market model of which the capital asset model (CAPM) is a part of, the profit from stock investing that investors expect should be as much as the risk they perceive that they are taking instead of the exact opposite which we find to be the case when actual research is performed on the matter.

This result caused the death of CAPM beta that was treasured by efficient market theorists despite the fact that the model resulted in the awarding of a Nobel Prize in economics to William Sharpe of Stanford University. Hirsh Shefrin has suggested that a behavioral beta be introduced into the model that might help explain these results that are contrary to market efficiency.