Guaranteed Stupidity

by Mike Holman

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I’ve been of the opinion that financial products that guarantee that you won’t “lose” any of your original investment and also offer an upside due to an equity component are not a good deal because of the high fees involved. Jonathan Chevreau covers some of these products today in his blog and article which got me thinking about the fact that financial companies are no different than any other companies in that if there is a market for a product then they will produce that product and try to make as much profit as possible. The reason that it’s possible for them to offer inferior financial products at a profit is simply because of the ignorance of the consumer.

If an investor buys a principal guaranteed product which entitles them to get their original investment back regardless of how the equity portion does, have they really conserved all their capital? In fact if you invest $10,000 today and then sell the investment in 10 years for $10,000 then your investment will be worth only $7374 in today’s dollars at 3% inflation. Inflation is one of the more important aspects of financial planning and cannot be ignored.

That investor would be better far better off to create their own low cost portfolio of at least 40% equity in order to keep up with inflation.

Even if said investor was still willing to ignore inflation and wanted to guarantee their “principal”, what they should do is create their own guaranteed product by buying a combination of GICs and equity (low cost index funds or ETFs). If for example you could buy a 10 year GIC at 4% then the above investor could invest $6755 in the GIC and the remaining $3244 in a couple of equity index funds. After 10 years, the worst case scenario is the equity component is worth $0 and the GICs will be worth $10,000 which will mean that the investor still has his original $10,000. A more likely scenario is that the equities will obtain a return – let’s say 7% which will mean that the equity portion will end up being worth $6382 and the final investment will be worth $16382 which gives the investor a return of 5% which beats the inflation by 2%. Obviously over a 10 year time period the equity returns could vary greatly.

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{ 9 comments… read them below or add one }

1 moneygardener

The instict to try to not lose money is far more powerful than the instict to try to earn money. It’s human nature.

2 FourPillars

MG – well put. Considering that not losing money is reasonable strategy, I guess the trick is to find the balance between being too conservative and too aggressive with investing.

Mike

3 ThickenMyWallet

Remember the investment industry preys on fear. Its easy to scare someone into thinking that they will lose all their money investing it themselves but if you think about it logically, you have to try hard to lose your principal over a period of time.

4 TheFinancialBlogger

Hi FP,
I wrote a similar article on how GIC’s are not that great:
http://www.thefinancialblogger.com/financial-cliche-vi-gic%e2%80%99s-preserve-my-capital/
In French, a GIC is a CPG (Certificat de Pauvreté Garantie!)
Cheers,
FB.

5 FourPillars

TMW – If you invest for the long term then you would have to have a very speculative portfolio to lose your capital.

FB – that’s a good post on GICs.

Mike

6 Canadian Capitalist

Most people, even if they are otherwise highly educated, are not financially very aware. So, it is easy to prey on their fears and generate more fees.

7 homeinboca

I recently received information on a Blue Chip note that guarantees your capital back. Besides locking in your money for 8 years, they can call the note after 4 years at a fixed rate which of course they would do, if the notes are worth substantially more. So they get all the updside with no risk.

8 FourPillars

Thanks for the info HomeInBoca: Can I assume you didn’t buy it? :)

9 FourPillars

Thanks Mr. C. – good Bernstein tie-in.

Mike

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