‘Want the flexibility to maximise gains and minimise losses?’
‘Take advantage of rising markets and protect the downside’
‘High income with a capital guarantee’
Whenever I see these sorts of headlines or slogans, I get a shiver down my spine… and any prudent investor should run for cover. Why? Because there is always a catch.
Firstly, we need to acknowledge that there is nowhere an investor can put their money with 100% certainty of no risk. There are always risks of some kind and we simply need to understand what the risks are and make sure we are comfortable with them, even if they are very unlikely. A couple of extreme examples are:
- One of the risks of putting money under the bed is that you could get robbed.
- One of the risks of running your own business is that the business is not successful.
- One of the risks of buying US Treasuries (considered the safest investment in the world) is that the US defaults.
This does not mean we don’t take any risks; it just means we need to be comfortable with the risks we are going to take.
We see ‘headlines’ such as those above in the newspaper, on the internet, on television and unfortunately sometimes recommended by advisers; whether they be financial advisers, accountants, lawyers or your know-it-all brother-in-law. Often the real risks of the investments being promoted are not fully disclosed (or are in the fine print) and they make it sound like you can’t lose right? WRONG!
These are some key things to look out for.
1. Return OF capital (not just return on capital)
It doesn’t matter what return you get, if you don’t get your initial money back! Many people forget this when they see investments that makes big promises and ‘guarantees’. It is critical to understand WHO is giving the guarantee and what the UNDERLYING investments are. An example of this going wrong in the last five years has been with Mortgage Funds and High Yield Funds. Investors were promised income returns higher than cash. But the problem was that the invested money was going into high risk areas with a low likelihood of the money being returned. This led to a lot of people’s money becoming frozen or investor’s losing their money.
2. ‘Downside protection’ when investing in shares
The important thing when you see products like these is to understand HOW the protection is being obtained. This is done using ‘derivative’ instruments such as futures and options. There is nothing fundamentally wrong with this, however there are costs associated with using such instruments. This means that these products come with very high fees and ultimately can negate much of the long term returns you might achieve.
The solution to this is only investing in shares for a long term strategy, which removes the impact of temporary drops in the market. Well diversified share portfolios will remove the risk of permanent capital loss.
3. Understand the risk of security
If you are fortunate enough to have more than enough money to provide the cash flow you need for the rest of your life, then you may be able to afford to ignore returns, which means you can hold everything in highly secure investments. However, for most of us it is very important that our income increases over time, to cover our increasing expenses such as bills, utilities and groceries. In this instance it can actually be risky to hold your money in cash, where the investment will not grow at a rate higher than inflation. Sure we might have security, but we won’t have enough money to live.
This is when it is ok to take some ‘volatility risk’ with a portion of our money to provide some longer term capital growth. This is a risk that can be understood and therefore managed.
At the end of the day, we need to be aware of the ‘marketing’ that is out there. Marketing that is intended to lure investors into products potentially for the benefit of someone else. The key is to understand any investment being considered. And the best way to do this is to seek professional advice from someone that is working in your best interests.