Everything Has a Risk
(Written in 1996)
"A CD Alternative paying 10% for one year, 100% guaranteed!" proclaimed the radio announcer. Sounds great. That’s about 4%-5% better than you can get at the bank and most highly rated insurance companies. If you are careful with your money and know anything about investment markets, you have to be thinking, now what’s the catch?
And you are right; there are a number of catches. First, the rate quoted is only for the first year. There is no guarantee that you won’t receive below market rates thereafter.
Second, it may be many years before you can withdraw all your money without a significant penalty. Third, and most important, the guarantee is only as good as the long-term financial health of the company offering this "CD Alternative". The product is actually a deferred annuity issued by an insurance company.
I could elaborate on some of the mathematical problems regarding this product, but I will simply ask the following question: How do you think the insurance company will be able to pay out 4%-10% in commissions to the agents, pay overhead costs of running the company and keep paying you above-market interest rates without taking some significant risks with your money?
The last 15 years have witnessed a growing number of insurance company failures, many of which occurred after promoting products with higher rates of return than could be obtained elsewhere. Unfortunately, many consumers’ greed outstripped their common sense as they bought these promises.
Safety is a relative term. While it is understandable that investors desire high returns with low risk, they often do not fully understand that these are conflicting objectives.
The larger working principle here is that the higher the return desired the greater the risk that must be assumed. Nothing can be 100% guaranteed to be risk free. Everything has a risk.
Let us consider a bank CD (Certificate of Deposit). While the FDIC (Federal Deposit Insurance Corp.) clearly promises to pay you your money back if your bank goes under, what is much less clear is when. It is possible you could experience significant delays. The money is yours, but you can’t get at it. Also, if there is a monetary crisis, you could get paid back in dollars worth a lot less than when you invested.
Also consider U.S. treasury obligations, viewed by most people as the safest type of investment. But is there any guarantee that the government could never experience a debt crisis, which would cause it to delay or even default on its obligations?
There is a big difference between lower risk and no risk. The point is that nothing is completely safe. It can only be "safer" than something else under a given set of conditions can. Change the conditions and the relative safety of the two investments can be reversed.
The CD Alternative commercial stated that you could get a 9% return without the risks of stocks, bonds or mutual funds. This is true in that the values of these change constantly. This is called volatility. The insurance company carries the annuity at a constant value, what you put in plus interest.
But what many do not understand is that the insurance company has invested your money in a portfolio that may include bonds, private loans and other assets, which have fluctuating values and varying degrees of risk. If the insurance company’s expenses become too high and the investment performance too low, you could find that a broadly diversified mutual fund could actually be "safer".
So next time someone offers you something 100% guaranteed, think twice and ask a lot of questions.