Principal protection: is it worth it?

PUBLISHED : Monday, 14 January, 2013, 12:00am
UPDATED : Monday, 14 January, 2013, 6:19am

When interest rates eventually trend up, banks will probably make use of the improved yield to start selling principal-protected and guaranteed instruments, whereby the initial investment sum invested is protected or guaranteed.

The instruments are aimed at conservative investors who want a promise they will get all money invested back. With low risk comes low returns. All things being equal, guaranteed instruments yield below investments where there is risk of capital loss, or not getting all your money back.

To be ready for a call from the bank salesman, investors should start to understand the basics of such investments.

For example, the investor should look at the creditworthiness of the firm issuing the instrument, as he or she will ultimately be relying on that institution to pay back the principal, no matter what happens to markets in the meantime.

Guaranteed instruments often involve structuring and complexity, and often with large embedded fees. They can be very difficult to sell prior to maturity, on the open market.

Investing is all about getting returns on risk. The higher the risk, the bigger the expected return. Clearly, guaranteed instruments are designed to be low risk. But ask yourself this: if the investment forms only a small part of your portfolio, could you plausibly afford to take losses on that investment?

If the answer is yes, you might as well forgo the guarantee structure, and choose something with more risk and more potential for returns.

In my view, principal guaranteed investments almost never make sense. Investors can control risk other ways - such as through a diversification of investments and counterparties - rather than asking a bank to guarantee minimum performance, which might only raise costs without providing sufficient benefits to justify them.

And practical considerations also play a role in investments, as with any endeavour.

If you're tempted to show the boss, family members and friends that you didn't lose money from an investment because of the protection or guarantee feature, please consider being completely honest by showing that, just because you get your principal back, doesn't mean that you didn't lose money.

It simply means that, years later, you will get the same amount of money that you started with.

We all know with today's inflation, that's a hell of a lot less than what you started with.

Robert Jones is head of FCL Advisory, which advises family offices and wealthy individuals