Cautious investors could easily become fooled by some of the investment options available on the high street; and judging by the millions poured into so called ‘guaranteed products’ investors must clearly be reading information I am not.
The biggest concern for investors is the potential for loss of their capital. Most of these types of ‘guaranteed’ or ‘protected’ investments will be sold via the high street in banks. They are typically marketed to those who have an aversion to risk, or as I prefer to say it, where the financial adviser neither explains risk or cannot explain risk.
Risk comes with a potential gain and a potential loss. Understanding what it means to you and can do for you is fundamental to your capital gains and protection.
If I opened a high class Christmas cracker it might say about risk ‘if there are strong winds, you can build a wall or a windmill’. Christmas is great.
So why might many investors be close to losing all their money when they believe they are protected?
These plans work as follows: A plan provider (a bank for instance) creates a product by placing some of your money with another financial institution. That financial institution offers a fixed return to the bank over a set period of time. So for example (in really simple terms) the bank is offered 5% per year over the next five years with UBS. The bank knows that if UBS pay that 5% per year they will have 25% (simple terms) in five years time.
And so they can place 80% of your money with UBS and in five years time the 80% will grow to 100% – hence your capital protection. The remaining 20% will be used to buy a range of complex financial instruments which participate in the upside of the stock market. So you might then see them marketed as ‘100% capital protection’* (note the very expensive asterisk) plus 60% of the upside of the stock market growth’ (typically the FTSE100).
Seems good? Prepare for the deluge:
There are three key points: Firstly the ‘capital protection’ only works at maturity (end of five years typically) and you have to ask yourself over how many five year periods in history has the FTSE 100 not returned at least your capital back? Rarely. So what value does the capital protection really have? None really.
Secondly, these ‘protected’ plans will not benefit from the yield in the FTSE100 (i.e. its dividends). This is currently running at c3.2%. (1) So if you were invested into a product such as that above you would be 17% worse off at the end of the term.
The most worrying issue however, is in relation to the ‘capital protection’. Remember these are aimed at investors who are risk adverse.
There is a potential with these plans that an investor could lose all their money, unlike the stock market where your capital simply fluctuates up or down. If the institution from which you are buying the capital protection goes bust, there is no protection under the financial services compensation scheme, due to the ‘large company’ rule. Therefore your money could be completely ‘out the window’.
And here is where companies put investors at risk. The lower the credit rating of the institution, the bigger the return they offer, so banks can simply move downwards with their choice of provider to then offer higher returns, catapulting your risk skywards.
A credit default swap (basically the cost of insuring a company’s debt) is a good analysis of a company’s strength. Today the cost of insuring £100 of Lloyds TSB’s debt (127.35) is 119% more expensive than the cost of insuring HSBC’s debt. (2)
This cute move of moving down the credit curve is putting millions of cautious investor’s capital at risk and they are oblivious to it.
If you have an investment query e-mail info@wwfp.net
Source:
(1) Invesco
(2) BSAM
About Peter McGahan and Worldwide Financial Planning:
Peter McGahan is the Managing Director of Worldwide Financial Planning – FT Award winning Independent Financial Advisers. Peter writes for many national and local press publications and is widely respected as an expert in personal finance. Worldwide Financial Planning specialise in the provision of expert one-to-one advice in the areas of Mortgage, Business Finance, Investment, Pension and Retirement Planning and Inheritance Tax.
Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. ‘The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.’ Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on our understanding of current tax practices, which are subject to change.The value of shares and investments can go down as well as up.