Guaranteed Pitfalls

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.