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FOOL'S EYE VIEW
Guaranteed Stock Market Returns

By Maynard Paton (TMFMayn)
October 31, 2001

Carburton Street, London -- The FTSE 100 has been in freefall for nearly two years. And a lot of investors are worrying over further stock market declines. Capitalising on this fear, financial service organisations are scrambling to promote products that "guarantee stock market returns". But beware. While the returns from such products will undoubtedly be guaranteed, they'll often be well below what you could normally expect from the stock market.

Promoted by a building society, here's a typical example of one such "guaranteed" product:

"[We are] providing savers with an outstanding investment opportunity, with the launch of a 5-Year Guaranteed Growth Bond. This innovative product offers the potential to achieve an incredible 50% growth, without any risk of capital loss...In addition, the bond also guarantees an absolute minimum growth of at least 22% of the initial investment over the five years, irrespective of any changing financial or economic circumstances".

It all sounds very tempting, especially with the stock market's performance of late. But for those considering this type of product, it's really worth examining how the guaranteed returns stack up with history. So, using data supplied by the CSFB Equity-Gilt Study let's address the product's potential.

Minimum

We'll start with the 22% minimum return, which equates to an annual compound return of 4.06%. On the face of it, it's not a generous figure, especially when the CSFB study highlights a historical 12% annual stock market return. (It's also worth noting that even five-year gilts (government bonds) yield 4.5% at the moment.)

Anyway, with the 22% figure in mind, how has the stock market performed during five-year periods in the past? According to the CSFB study, 66 (or 79%) of the 84 different five-year periods since 1918 have beaten the product's 22% minimum return.

Given the market's recent performance, it's also worth bearing in mind how the FTSE 100 has done over the past five years too. During the final two months of 1996, the FTSE 100 hovered around the 4,000 mark. At the moment, the index is now hovering around the 5,000 mark. So even with all the turmoil of late, the last five years have still produced a 25% gain and beaten the product's 22% minimum.

Overall, when it comes to general stock market returns, you can safely say having a guaranteed 22% return over five years is not a mouth-watering offer.

Maximum

Now let's turn to the maximum possible return, that 50% over five years. This figure equates to an annual compound return of 8.45%. This sounds more reasonable, but still short of the 12% historical average. What's more, according to the CSFB study, 58 (or 70%) of the 84 different five-year periods since 1918 have beaten the 50% maximum return, too.

So once again, when it comes to stock market returns, you can safely say having a maximum 50% return over five years is not a must-have deal either.

Funny business

However, what about the returns in between 22% and 50%? How are they judged? In this case, investors have to be very careful. With products offering "guaranteed returns", esoteric criteria to confuse the unwary abound.

With this particular five-year bond, the "middling" returns are based on three leading indices: the FTSE 100, the S&P 500 and the DJ Eurostoxx 50. It works like this. If all three indices report three annual increases over the five-year term, you get a 24% return. However, if the three indices report four annual increases each, you get a 32% return. And if all three indices report an annual increase every year over the whole five-year term, you get the magic 50%! But get any other combination of index movements, and you're stuck with the 22% minimum.

You don't need to be a stock market expert to guess the likelihood of three leading indices rising every year for five years. By looking at just one of those indices, you can tell the odds are slim. Since 1918, the CFSB study highlights how the UK stock market has fallen in nearly three years out of every ten. Going by history then, there's a good chance the FTSE 100 will fall in at least one year over the bond's five-year term and dash any hopes of that maximum return.

Summary

Ordinary investors typically don't read up on stock market history. But you can be sure financial product providers do. As we've seen by the features of this guaranteed product, the odds are stacked against the investor in terms of outperforming the overall stock market.

Sure, investors will get anything between 4.06% and 8.45%. But all those index-based conditions suggest returns at the lower end of that range will be generated. Indeed, having those somewhat odd conditions attached to a financial product is a danger sign in itself.

But rest assured, whatever the bond's final return turns out to be, the product provider will almost certainly beat it by reinvesting investors' money on the stock market. That's how the product provider generates a profit for itself. For long-term savers, it's far better if you pocket those greater returns through a straightforward index tracker.

More: Yet More Guaranteed Stock Market Returns