The friends-with-benefits of index funds?

Recently a Facebook friend of mine brought up the “friends-with-benefits” he’s getting by investing in index funds.

And, it seems the new “holy grail” of investment portfolios is the “Three Fund Portfolio” or “3FP” for short. If you’re familiar with index fund investing, you’ve likely heard of it before.

It’s not actually new at all but it’s becoming trendy to SAY that it’s new and to start modeling your portfolio after it.

If you’re not very familiar with the index fund crowd, the investment portfolio is comprised of just 3 low-cost index mutual funds: A U.S. stock fund, an international stock fund, and a bond fund.

This combo is supposed to decimate all which stands in its way.

Bogleheads (that’s what they call themselves — the folks who whorship John Bogle, the founder of Vanguard) are nothing if not meticulous, keeping careful records of annual returns and so they made my job of seeing the results very easy.

Over the last 20 years, the 3FP has done pretty well, earning a compound annual return anywhere between 6.89% and 5.55%, before taxes.

After taxes, you’re looking at somewhere in the neighborhood of between 4% and 5.5% net return for most people. Some people would have earned around 6%, net.

Of course the real question implied in this discussion is: how well does this compare to using life insurance?

I hate these sorts of comparisons, because I really and truly believe there is a place for investing and sometimes even speculation.

But, the Internet, being what it is, is obsessed with comparing two dissimilar products with two dissimilar risk profiles and then… declaring a winner based on a hypothetical return which cannot be proven to occur sometime in the future.

Seems legit.

Anyway, I’m not afraid to get my hands a little rank, so I looked at what all the hoopla was about.

When you look at the returns for a plain-jane whole life policy from a major mutual life insurer like MassMutual or maybe New York Life, or The Guardian, or Penn Mutual, over the last 20-30 years, your returns are about 3.5% to 4.5% on cash value, with exceptional whole life products (or customized policy designs) returning over 6% on cash value… which is obviously not that different from the 3-fund portfolio.

Wait. What?

How can that be?

Are insurance companies really that good or are stocks really that bad?

Neither, Mortal.

Insurers have benefited greatly from 30- odd years of generally falling interest rates. This has helped them stay ahead of actual market rates because they bought bonds yielding double-digit returns and then watched the value of those bonds SOAR as interest rates fell in the marketplace.

Now that that gravy train is gone, it’s back to the grind for yield.

Insurers are excellent money managers, though, and they run highly profitable businesses, which accounts for the strong performance on cash values in the current low-yield environment. At the same time, the stock market as a whole has done pretty well over the past 20 years, considering.

The difference is in the general risk investors took adopting these strategies and also the reasoning behind investing directly in the stock market versus using a life insurer as your money manager.

Here’s what I mean:

Whole life policy owners took zero risk of loss during this time period, since they paid the insurance company to shoulder ALL the risk of loss… they could use their cash values without interrupting the compound growth (or with minimal interruption of growth), and also got life insurance in addition to savings. Meanwhile, index fund investors had a standard deviation between 3.83% and well over 14%, so their returns jumped around a lot during those 20 years, they had to buy term insurance if they wanted insurance protection, and they had to stay invested the whole time to see the benefit of those investments.

In my weird way of thinking, it don’t make no sense to take risks you don’t have to take, which is why I advocate an insurance-centric approach to financial planning instead of an investing-centric approach.

It doesn’t means you have to eschew investing. In fact, there comes a point when investing makes a lot of sense. It’s just not the foundation of a financial plan and it’s not the risk-free panacea everyone tells you it is.

David Lewis

This post brought to you by //The Rogue Agent//. David has been a life insurance agent, and worked with some of the oldest and most respected mutual life insurance companies in the U.S., since 2004. Learn more about him and his business, here.