(photo credit: Wikicommons)
The recent talk of “tapering” has brought back intense volatility to the
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
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.
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)
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 email@example.com Aaron Katsman is
a licensed financial adviser in Israel and the United States who helps people
with US investment accounts.