The Free Lunch from Guarantees May Come at a Hefty Cost

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 just a few. However, I’d like to argue that with the cyclical nature of the stock market, comes a certain cyclicality in investor behaviour and sentiment too: we often find that 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, like fixed deposits and guaranteed products, seem to be subject to this cyclicality. Earlier this year, it was reported that FNB had “seen its fixed deposits grow by a compounded annual growth rate (CAGR) of 22% in the past six months,” making up 12% of the group’s total assets. Their inaugural retirement savings survey also 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 (GFC) 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.

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 fuels 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.

However, as with all things in life, nothing is free. There is, after all, a cost for the issuer providing the guarantee. To digress for a moment and as something of a public service announcement – investors are also well served to remember that promises of unrealistically high guaranteed returns (well above the prevailing interest rates offered by banks) are one telltale sign of pyramid schemes! The key point to remember, however, is that providers offering (reliable) guarantees still need to fund them somehow – and they take a prevailing view on the markets and rates when doing so.

In an uncertain environment, equity returns are prone to temporarily 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 of time. True wealth is built in the equity market – not in fixed income investments. In the words of author Robert G 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 reliably outperform inflation and grow their wealth in real terms.

But what derails many investors, is that stock markets do not generate returns in a straight line. There are bull runs, of course, but also long periods of sideways trading and – do I need to remind anyone? – 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. However, 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, like that 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.

In the scramble to guarantees that we often see in the midst of equity market lows or protracted mediocre returns, this is often what investors forget. While there is a place for products that offer certainty as part of an overall balanced portfolio, investors should remember that the price of the guarantee is not just in the return that you lock in, but also in the future returns you give up by being out of equity markets. The same high interest rates which 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.

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. By consistently applying our proven 3M investment methodology, and buying quality assets at below their intrinsic value, PSG Asset Management aims to unlock value for investors in the long run. While 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 due to temporary factors – or based on incorrect assumptions of their true value. Reratings in such neglected assets can be breathtaking, when the time comes. Shipping and leisure stocks, which could be bought at mouthwatering levels a few years ago, come to mind.

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 like PSG Asset Management, which 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.

Anet Ahern is the Chief Executive Officer of PSG Asset Management.