Your Investments

By AARON KATSMAN
July 29, 2010 09:33

How to preserve your capital

3 minute read.



money 88

money good 88. (photo credit: )

As global financial markets continue their roller-coaster ways, and with deposit and bond yields returning next to nothing, many investors are searching for ways to still have market exposure but without 100 percent of the risk.

Risk vs reward

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Most investors are familiar with the principal: The more risk you take, the greater the potential reward. Conversely, minimum risk usually implies limited or low returns. How do you know if “risk” is for you? It helps to know what kind of an investor you are, or what type of personality you have. Are you the type of person who enjoys the ups and downs, twists and turns of a roller coaster? Or do you take one look at that roller coaster and head straight for the merry-goround instead? The reward for holding on to your investments until the end of the rollercoaster ride is that they may grow in value. You have to be willing to hold on through the long term in hopes of reaching your goals. If you go the slower route on the merry-go-round, your investments will probably fluctuate less but may not reward you as much in the long run.


Structured products

Over the past 15 years, investment companies have created products that combine exposure to growth with the safety of a deposit or a bond. They succeeded in creating what are termed capital- or principal-protected structured notes. These products allow investors to share in the upside of some predetermined stock index or other asset class while guaranteeing the initial principal invested.

A typical product may look like this: four years; linked to the performance (80%) of the S&P 500 Index or Japan’s Nikkei 225 Stock Average; principal guaranteed. Let’s take a look at what this actually means: product matures in fours years; linked to a particular index where the investor receives 80% of the upside, if any, of that index; initial investment (say $20,000) is guaranteed.

In the worst-case scenario, which is if the index drops after four years, you get your money back.

Too good to be true?

If something sounds to good to be true, it probably is. So the question begs asking: Where’s the catch? It’s very important to read the small print and understand the structure of each individual product. In the aforementioned example, while it’s true that in the worst-case scenario you would recover your initial investment, after investing your hard-earned money for four years, most investors would expect some kind of positive return. After all, during that time period, while inflation was on the rise, you actually lost money.

Keep in mind that a FDIC-insured bank deposit for four years will return approximately 2.5% per year, which means, had you invested differently, you could have increased the value of your investment by close to 10%. For many investors, forgoing a paltry 10% over four years is worth the chance of a much higher return.

Other issues

When reading the fine print you may also find the following terms:
 • Capped upside: To make sure your principal is secured, you must sometimes sacrifice the maximum amount you can make. For example, the deal might limit your positive return to 8% in any one year. While that might sound fine, keep in mind that that is not much participation in the index.

Liquidity: Structured products are meant for people who intend on holding their investment until maturity. The principal protection guarantee doesn’t apply to people who liquidate early. It’s quite common that if you want to sell before the program is over, even if the underlying investment has gone up, you’ll end up getting back less than you paid. Why? Because there’s not much of a secondary market for these investments, and the redemption fees take their toll.

Speak with your adviser

While structured products may seem ideal because of the growth potential and the principal protection, keep in mind that you need to understand what the terms of each product are prior to investing. Before you consider purchasing them for your portfolio, it’s a good idea to speak with your financial adviser to determine how, and if, they fit into your financial plan.

aaron@lighthousecapital.co.il Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people open investment accounts in the US.


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