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FOOL'S EYE VIEW
Guaranteed Returns from the Stock Market

By James Carlisle
June 15, 2001

I thought that title might get your attention. It's a trick I borrowed from the purveyors of "guaranteed stock market products", who always work it into their advertising straplines. To emphasise the point, an advertisement landed on my desk this morning asking "would you like a share of the excitement of the stock market, without the risk". Well, yes, I would actually. Of course I would!

No such thing as a free lunch

Unfortunately life just isn't as simple as that. Almost inevitably in finance, when something looks too good to be true, then it isn't. You have to pay for the guarantees on the product and, financial markets being what they are, they'll cost you at least what they're worth (plus a bit, often a lot, to give the provider a profit).

The product in front of me is structured as a "Guaranteed Equity Bond" and you can participate in the upside of the stock market, represented by the FTSE 100 but, whatever happens, you get at least your original investment back after 6 years. The problem is that your returns are capped at 15% each and every year. So, if the FTSE 100 were to rise, say, 20% in a year, then someone else is going to keep the extra 5% -- and that's the cost of guaranteeing your initial investment.

Someone, somewhere, has looked at how often the FTSE 100 beats 15% in a year (and by how much) and how often the FTSE 100 would have missed returning your money over 6 years (and by how much) and worked out that it's worth their while taking the other side of the bet that you, the investor, is being offered. And, of course, if it's worth their while, then it's not going to be worth yours.

A One-Sided Bet

The FTSE 100 only goes back to 1984 and is generally quoted without dividends so I've used the historic total returns for the London Stock Market since 1918 provided by CSFB. What it shows is that, over all the 6-year periods starting since 1918, only twice would the London Stock Market have lost money (and therefore caused the finance company to pay out on their bet). These were -4% in 1925-1931 and -48% in 1968-1974.

So our friendly finance company would have to had paid out only 2.6% of times that it took the bet since the First World War (and on one of those occasions only barely). You on the other hand would have had to pay the finance company every time the stock market passed 15% in a year (other than the two occasions when it paid you). This has happened in a (surprising) 38 of the 83 completed years since 1918.

By my calculations, in the 75 6-year periods that it would have won the bet since 1918, the finance company would have made an average annual return of 7.5%. That leaves, on average, just 4.7% for you (the average return of the market being 12.2%). In return, you've received a guarantee that has effectively only been useful to you once in 75 times. That's a very one-sided looking bet.

Of course just because you have to pay over the odds for what you get doesn't necessarily mean that it isn't worth it. Part of the reason for the existence of banks and insurance companies is to moderate our risks and it's fair for them to take a small profit for doing so. If you absolutely have to avoid the small chance of a loss over 6 years and want the chance to beat a savings account, then this type of product could conceivably make sense. The trouble is, of course, that you have to pay so much for the privilege that it's very unlikely to be worth it.

Keep It Simple Stupid!

The moral of all this is that there are no free lunches and, most particularly, to be very wary of financial products that fly in the face of the "KISS" mantra (keep it simple stupid!).

As a rule of thumb, the more opaque a financial product, the more scope for the provider to hide away an extra bit of margin for themselves. That extra margin just serves to shift the bet further in their favour: not only is there no such thing as a free lunch, but we find that the more exotic the menu, the more overpriced we're likely to find it.

So, although these exotic financial products can sound tempting and, in very, very rare situations they might even make sense, they're best kept firmly at the bottom of your list of investment options.