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Hidden Costs Of 'Protected' Stock Market Growth

By Maynard Paton (TMFMayn)
August 13, 2002

"If you're looking to maximise returns with a significant level of capital protection, consider the Protected UK Growth Plan. The Plan provides all the growth of the top 100 companies listed in the UK (FTSE 100) over the next five years with no upper limit, but with a high level of protection against stock market falls."

To many investors burnt by the bear, such a promise sounds attractive. The marketing blurb was taken from one of an increasing number of products that offer stock market growth but with built-in downside protection. However, there is a hidden cost to such plans.

This particular product works as follows. You put in a lump sum for five years and your return is directly linked to the performance of the FTSE 100 -- so long as it goes up. If it goes down by less than 50%, then you get your money back. However, if it falls by more than 50%, then your return is again linked to the FTSE 100 (if it falls by 51%, then your investment falls by 51%, and so on).

On the face of it, the product seems a good bet. With the stock market presently at a five-year low, what are the chances of it falling another 50% in the next five years? Unless the bear market to end all bear markets is upon us, very slim. So the worst you'd probably do is come out breakeven by 2007.

So where's the catch? Dividend payments.

You see, this protected product does not include the reinvestment of dividends. And that's quite important for the long-term investor. Over the past 80 years or so, the stock market's annual real return would have reduced from 7-8% to 3-4% without the benefit of reinvested dividends. At 4,200, the FTSE 100 currently offers a dividend yield of about 3.3%. If blue chip companies maintain their payouts then, in simple terms, this product will take away about 16.5% (5 * 3.3%) from your potential gain over the five-year period.

So this 'protected product' penalises you by about 16.5% over five years if the FTSE 100 actually rises and, if it falls by more than 50%, it doesn't give you any protection. Only in the middle -- between 50% down and 16.5% down -- do you stand to gain any advantage over a simple tracker. It's a slim advantage and you're paying a huge price for it. If you have money that you can't risk exposing to the stock market, then you're best to leave it in the bank.

More: Guaranteed Stock Market Returns | Even More Guaranteed Stock Market Returns