Your Investments: Preserving your capital

The recent talk of “tapering” has brought back intense volatility to the financial markets.

July 4, 2013 22:18
4 minute read.

Money. (photo credit: Wikicommons)

The recent talk of “tapering” has brought back intense volatility to the financial markets.

Federal Reserve Chairman Ben Bernanke’s comments outlining what it would take for the Fed to stop buying back bonds sent stocks dropping, gold plunging and interest rates soaring. Investors the world over have begun to worry whether this drop is the start of something much larger. After all, we have seen multiple market crashes over the past 13 years.

Unfortunately no one can continually predict what will happen in the future. As such, many investors are looking for a way to truly protect their principal while having some potential for some capital appreciation.

Risk vs reward When it comes to investing, there is a general principal that 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-go-round instead? The reward for holding on to your investments until the end of the roller-coaster ride is that your investments 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-goround, your investments will probably fluctuate less but may not reward you as much in the long run.

Structured products Over the past 20 years, investment companies have sought to create products that merge the 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, and they guarantee the initial principal invested.

A typical product may look like this: four years, linked to the performance (80 percent) of the S&P 500 stock index or the Japanese Nikkei stock index and principal guaranteed. Let’s take a look at what this actually means. The product matures in four years, it’s linked to a particular index where the investor receives 80% of the upside, if any, of the particular index invested in, the 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? As I have mentioned previously in this column, if something sounds to good to be true, it probably is. So the question begs asking: “Where is the catch?” It’s very important to read the small print and understand the structure of each individual product. Not all structured products are created equal, and more than once has one blown up and cost investors everything. (Just ask Orange County back in the 1980s).

Retail investors should probably stick to vanilla-type products. 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 you actually lost money because inflation increased. Keep in mind that an investment-grade corporate bond for four years will return approximately 1.5%-2% per year. That means had you invested differently, you could have increased the value of your investment by close to 8%.

Some other issues When reading the fine print you may also find the following terms: • Capped upside: In order 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 to hold 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: 1) there’s not much of a secondary market for these investments; 2) redemption fees.

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 Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.

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