‘The free lunch from guarantees may come at a hefty cost’

The cyclicality of markets and investing is often recognised at the macro level: bull and bear markets, commodity super cycles, the outperformance of value or growth stocks at various times, to name a few.

Anet Ahern, the chief executive of PSG Asset Management, argues that with the cyclical nature of the stock market, comes a certain cyclicality in investor behaviour and sentiment: similar topics crop up predictably from time to time as market movements and cycles play out.

The popularity of products that promise certainty to investors, such as fixed deposits and guaranteed products, seem to be subject to this cyclicality. Earlier this year, it was reported that First National Bank had “seen its fixed deposits grow by a compounded annual growth rate of 22% in the past six months”, making up 12% of the group’s total assets.

FNB’s inaugural retirement savings survey found that 86% of respondents use banks as one of their retirement savings channels.

“I can recall two previous occasions when the flight to guarantees was tempting and popular – in the early 2000s and after the 2008 Global Financial Crisis period. During both of these periods, one ultimately wanted the ability to take advantage of market opportunities, but guarantees and fixed deposits often require giving up that flexibility,” Ahern says.

“We can guess why interest levels in guaranteed products seem to coincide with tough times in the market: investors (much like markets) detest uncertainty, and high interest rates (which fuel economic uncertainty) are a key input into structuring guarantees, and make fixed deposits appear attractive. Paying for certainty in an environment marked by uncertainty seems like a sure win,” she said.

As with all things in life, nothing is free. There is, after all, a cost for the issuer providing the guarantee. Providers offering guarantees need to fund them somehow – and they take a view on the markets and rates when doing so.

In an uncertain environment, equity returns are prone temporarily to dipping below the rates on offer from fixed-income investments. But normally equity markets offer far higher and – importantly – real returns to investors in the long run. And they have done so reliably over long periods.

True wealth is built in the equity market – not in fixed-income investments. In the words of author Robert Allen: “How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”

While cash and fixed-income investments play a hugely important role in meeting short-term and income needs as part of an overall balanced portfolio, those investing for the longer term need to outperform inflation reliably and grow their wealth in real terms, Ahern said.

Returns are dependent on where you start

What derails many investors is that stock markets do not generate returns in a straight line. There are bull runs, but also long periods of sideways trading and steep drops. Therefore, it follows that the returns generated from any point forward are dependent on the starting point. Those buying in at the top of bull markets are likely to wait a long time for markets to regain their former highs, as an example.

What many ignore is that weak and depressed markets contain the seeds of great future returns. Consider the sharp upward spike we often see following a deep market low, such as the one following the Covid-19 crash. The difference between returns when investing at the top of bull market euphoria versus bear market fear can be substantial, Ahern said.

In the scramble to guarantees that we often see during equity market lows or protracted mediocre returns, this is often what investors forget.

There is a place for products that offer certainty as part of an overall balanced portfolio. Yet, investors should remember that the price of the guarantee is not only in the return they lock in, but also in the future returns they give up by being out of equity markets.

“The same high interest rates that make guaranteed products so tempting, and sentiment around growth assets poor, sow the seeds for attractive equity returns in the future off the base of low valuations and strong price responses to negative sentiment,” Ahern said.

Market timing, of course, is virtually impossible to get right, and it is here that the importance of following a tried-and tested investment process comes to the fore.

“Although at the aggregate market level there may not always appear to be buying opportunities, there are always neglected or unloved assets and sectors of the market that investors shun because of temporary factors – or based on incorrect assumptions of their true value. Re-ratings in such neglected assets can be breathtaking when the time comes. Shipping and leisure stocks, which could be bought at mouth-watering levels a few years ago, come to mind,” Ahern said.

Investors looking for more certainty from their portfolios should therefore always consider not only what they are getting at face value, but also what the long-run impact of their decision might be on their ability to grow their long-term wealth.

An investment manager that seeks neglected quality trading at depressed valuations on a globally integrated basis is well placed to uncover hidden gems that help to tilt the odds of long-term success in the investors’ favour as part of a balanced portfolio.

An adviser who understands the investor’s overall picture can blend asset classes and funds that provide growth with those that provide predictability in a way that serves the investor’s future needs best, taking overall risk levels into account.

Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article does not constitute investment or financial planning advice that is appropriate for every individual’s needs and circumstances.