Guaranteed Pitfalls


Posted by: Swindells FP, on July 5, 2013.


It is the nature of investment that people will pay a premium for the promise of a “certain” outcome. But research shows these supposed guarantees often come with hidden costs and risks attached.

Imagine an investment product that is sold as lifting your chances of meeting your retirement needs from 60% to 65%. A second product proposes to increase your chances from 95% to 100%. Which is more valuable?

It seems clear that while both products offer a 5 percentage point increase in the probabilities of success, the second option is much more enticing. This is known as “the certainty effect” and is well documented among investment behaviouralists.

According to this effect, we are predisposed to overweight small risks and will pay far more than the expected value to eliminate them altogether.

It shouldn’t be a surprise, then, that an entire industry is based on the innate desire among consumers for perceived certainty in investment outcomes.

This industry produces what are known as “structured” products. These instruments are often marketed to consumers as “capital guaranteed” or “capital protected” and offer the prospect of a certain payoff in the future.

A recent study of this industry concluded that these products can entail complexities, conditions and risks which are not always well understood and which can deliver unintended outcomes.

While the products are sold as ‘guaranteed’, there are often mitigating phrases such as ‘qualified’, ‘limited’, ‘conditional’ or ‘contingent’ – all of which hold out the possibility that the whole of the investor’s capital may be at risk.

Some investors may wrongly consider structured products to be equivalent, or a near equivalent, to cash or deposit accounts, when the risks of structured products are usually considerably higher.

Further problems with structured products include an opaque structure, which often exaggerates the likelihood of payoff and/or underestimates the fees to be incurred. Product issuers, while notionally being associated with a major financial institution, may in fact be separate entities with little financial substance.

Some products, through the use of internal borrowing, also carry significant potential for investors to lose money beyond their initial investment. Others carry conditions that link the pay off to the performance of an underlying asset.

A lack of ease of access to your money is another frequently cited problem with structured products, as are uncertain tax consequences.

Even if none of these risks are present, the guarantee of a pay off has to be weighed against the lower return than might be secured otherwise and the often higher fees than incurred by investing in simple stocks and bonds.

It is understandable that people would prefer to eliminate risk altogether than merely reduce it. But the perception of certainty and the reality are often far apart. And the cost of seeking a guarantee can be much higher than we anticipate.

As always, beyond diversification, there are no free lunches in investment.



|

Enter your email

Get free investment, pensions and wealth management news and advice.

* indicates required

*We will never share your details with any third party.


Categories



Client Stories





Book a consultation


Your Name (required)

Email (required)

Phone Number

Age

Employment Status

Income

What you would like to talk about?

captcha

Enter exactly what you see above






Enter your email to receive free relevant news and updates.

* indicates required

*We will never share your details with any third party.


Latest… View all




Putting the current stock market decline in context


There’s no doubt hyperbolic headlines depicting the recent falls on the world’s financial markets are potentially anxiety-inducing. With the FTSE 100 Index falling to its lowest level since April 2017, the effect of the headlines is to promote a sense of uneasiness; we’re here to remind you that this shouldn’t be the case. Instead of […]

Read more →


Inheritance Tax is an avoidable tax


It is often said that Inheritance Tax is an avoidable tax, but many of us somehow fail to avoid it. Why is this? In our experience, clients’ failure to plan effectively is a result of the following perceived problems: Speed – How often will the thought of having to survive 7 years from the date […]

Read more →


What went wrong with the forecasts?


Reading the tea leaves Investors at year-end are inclined to reflect on the 12 months gone and muse on what the coming year might bring. Aware of this appetite for speculation, themedia tends to feed it with forecasts. These articles can be fun to read, but are even more so a year later. In January […]

Read more →


What should investors make of bitcoin mania?


Bitcoin and other cryptocurrencies are receiving intense media coverage, prompting many investors to wonder whether these new types of electronic money deserve a place in their portfolios. Cryptocurrencies such as bitcoin emerged only in the past decade. Unlike traditional money, no paper notes or metal coins are involved. No central bank issues the currency, and […]

Read more →