As markets are hit by uncertainty thanks to US President Donald Trump’s ongoing trade spat with China, fresh Brexit drama and talk of a global economic downturn, many investors are getting nervous and look for options that will provide set returns. One such option that often gains popularity during times of extreme volatility is a guaranteed product. A product where investors can be guaranteed that their capital investment will be safe as well as certainty around the rate of return on the investment. The products are marketed as a way to protect wealth, but is this appropriate, and when should you steer clear?
In his brilliant book “Predictably Irrational”, Dan Ariely details how humans believe that they are rational and make decisions based on logic and reason, however in reality the opposite is true. In fact, the case can be made that we use the logical part of our brain to justify the irrational decisions we make. Investing is not immune to this, in fact there is a whole branch of finance known as Behavioural Finance that looks precisely at the decision-making process that we go through when making an investment. One of the strongest factors influencing our decision making is loss aversion. We’d rather choose something of lesser value or quality that we know will not negatively impact us rather than choosing something that has the potential to positively impact us. Guaranteed products play right into our loss aversion behaviour. It gives investors great comfort to hear the word guarantee, but it can come at a cost
A guaranteed investment is fairly straightforward. Most guaranteed investments are fixed for a 5-year term, capital is guaranteed, and the return is not allowed to drop below a certain percentage. It sounds like a winning formula until you look a little deeper. The investment is a business transaction and the asset managers need to ensure that they are getting paid and earning the return that they need to. What do the asset managers do? Well, they often smooth the returns. That is, they create a band that the returns are allowed to be and anything above the upper limit of the band is used to fund the lower limit of the guarantee. Your money is still invested in the same risk, however the top-level return that you might have gotten is now being used, and often kept, by the asset manager to cover the cost of the return.
For example, you take out a guaranteed investment for R100.00 that says that your return cannot be negative. Your money is invested in a variety of asset classes including cash, bonds, equities, and property. The upper limit of the return is set up by the asset manager at 5% per annum. In this hypothetical example, after five years the investment would have grown to R123.00, however the actual return on the investment was R130.00, with R7.00 going to the asset manager.
This can form part of an investment plan but needs to be considered in a holistic approach to an investment plan, but some investors do seek comfort in these products even if for a short term, when markets are volatile. The value of these investments needs to be weighed up per product and the investor’s individual objectives.
Extensive research done over decades show that, over time, investing in equities delivers the best return. Read more here: Long term stock market returns.
However, there are certain situations when a guaranteed product is beneficial for an investor. For instance, a life annuity. A life annuity, sometimes called a guaranteed annuity, is an annuity that an investor takes out with an insurer as pension. The annuity works very much like an old-school pension fund. The investor transfers pension fund money, of say R1 000 000.00, the insurer then runs some calculations and determines that it can pay the investor an amount of say R10 000.00 per month, every month, until the investor passes away. The insurer carries the risk that the investor may live longer than the actuarial tables suggest, but they have a promise to pay the agreed amount every month until the investor dies.
A guaranteed investment protects investors against downside risk, but at the cost of any upside. Investors needs to be comfortable with the rate they can get with this type of annuity because once invested in such a vehicle, there is no opportunity to opt out and place it in a Flexible Living Annuity, for example.
The guaranteed annuity does have a place in a retirement plan for mostly investors that have not saved enough for retirement, or early retirees that have years ahead of needing an income. The bottom line is that medicine has evolved, and people are living longer so some investors get comfort in this type of investments.
It may be very tempting to consider a sure thing over a potential thing; however, investing is a long-term game, and it takes insight and experience to ensure that the desired outcome is achieved. It is always advisable to consult an experienced, qualified advisor for guidance. Details here: Brenthurst Wealth