By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business
Note: This article is not intended as formal financial advice. Readers should consult with a licensed financial advisor before making any financial decisions.
In the recently published Smart Personal Finance 101 series, Dr. Karin Ford-Torres and I alluded briefly to non-securities based investments like private real estate investment pooling through Fundrise and Realty Mogul. These are great ways to diversify an investment portfolio for those who are looking to spread and minimize their risk (which should be…well…everyone).
During the coronavirus pandemic, the stock market fell by more than 30 percent over a span of just seven days – experiencing record setting declines. This left a lot of investors who had been heavily leveraged on securities in precarious situations.
If another recession hits, it’s safe to say the stock market and most securities traded on it will tumble again – probably by double-digit percentage figures.
American Public University offers Accounting classes that include courses in financial management to prepare financial professionals to understand and navigate market dynamics such as these.
But “locked in” investments are particularly beneficial for diversifying risk and weathering market fluctuations. Private investment options like Fundrise and Realty Mogul did not lose much if any value during this crash. Why? Because these platforms force investors to “lock in” their contributions for minimum periods of time — usually three to five years. And withdrawing early comes at a penalty, just like early withdrawals from retirement accounts like 401ks and IRAs.
Understanding Locked In Investments
How exactly do “locked in” investments create stability? In order to understand this, it’s first important to understand the domino effect that occurs during nearly every stock market crash.
Whenever markets begin to dip, some conservative investors – fearing that it is just the beginning of a much larger decline – will sell their shares and liquidate their investments with the aim of cutting their losses.
However, this ironically becomes something of a self-fulfilling prophecy, because in so doing these investors can signal to other investors that it might be time to get out. And so those other investors observe the early departures and think to themselves “Hmmm…he’s leaving and she’s leaving…maybe I should leave too.” So they do. And this in turn adds to the volume of sell-offs that consequently trigger more sell-offs from others. And so on.
Markets fluctuate heavily on the dynamics of consumer confidence. So it’s easy for even a small dip in regional markets to snowball into global catastrophic financial collapse if the right number of people bail out at the right time.
How Locked In Investments Bring Stability
But that brings us back to the topic of stability in “locked in” investments. Locked in investments create stability because investors are far less likely to panic and bail in the event of temporary economic downturns. Because there is a penalty to be paid for abandoning an investment early, investors must stop and think carefully about the consequences of selling, and compare them with the potential outlooks if they stay in.
Investors are told about the “lock in” terms and the penalties upfront before they ever decide to put their money in the pot. So they know in advance that they will need to be able to tolerate some amount of market fluctuation before they can justify a decision to liquidate and walk away. Because that comes with its own cost…a cost they know they will have to eat if they go that route.
For example, suppose a locked in investment platform imposes a penalty of five percent forfeiture if an investor decides to pull their money out before it fully matures. And suppose that at some point during the investment maturity period the market drops by, say, two percent (not at all an uncommon occurrence – even on the S&P 500). At this point, the investor might be tempted to pull his money out in order to stop the bleeding. But it would not be wise for him to do so, because the penalty he would owe to the investment firm would actually be more than the potential loss he is looking at from the market. So if he did bail, he would lose the 2% drop in market value plus his 5% penalty – roughly a seven percent total loss.
If he’s focused on the long term, he’ll probably decide to stay in…unless of course he has good reason to think that the decline will continue. But even then, markets fluctuate and every decline that the stock market has ever endured in its entire history – including the crash of 1929 and other catastrophic implosions – have been temporary. It always comes back eventually. So a smart investor knows that if your investments lose value and you don’t need the money immediately, you should leave it alone – because eventually it’s very likely that you’ll recover.
And by the way, if you needed the money right away, you really shouldn’t have been investing it in non-FDIC insured investments in the first place.
So locked in investments are a smart addition to any investor’s portfolio. They help to diversify risk because with locked in investments we know that fellow investors cannot simply panic and bail without consequence the way they can with stock market holdings. And this makes it less likely that such investments will implode because of monkey-see-monkey-do sell-offs.
Of course, just because risks of such mass sell-offs are lower doesn’t mean they’re zero. And just because locked in investments offer some confidence doesn’t mean that anything is guaranteed. It’s important to remember that investment platforms like Fundrise and Realty Mogul are just as uninsured as the stock market. The key to smart investing is diversifying risk.
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