The Price you pay for Guaranteed Returns in Investments

Once you lose money in stock markets or any other investments, there is a natural tendency to shift to products that offer guaranteed returns or that seem to offer guaranteed returns. While it is important to make investments that are aligned with your risk appetite, you also need to make investments in line with your financial goals. You must appreciate that return guarantee may provide comfort but may have its costs, that of lower returns.

What are the investment products that offer guarantees returns?

There are quite a few products that offer guaranteed returns. A bank fixed deposit is one. Then, there are closer cousins such as post-office fixed deposits, NSC, Kisan Vikas Patra (KVP), Senior Citizens Savings Scheme (SCSS), Pradhan Mantri Vaya Vandana Yojana (PMVVY).

PPF, Sukanya Samriddhi Yojana (SSY) and EPF provide guarantee (albeit the returns can vary from year to year).

The regular readers would know that I like PPF, SSY, and EPF very much, I like SCSS and PMVVY for generating income from retirement portfolios.

I am fine with such products as long as you are fine with such post-tax returns. You know what you are getting pre-tax and post-tax.  And you make an informed choice. However, you must consider the long-term impact on wealth and feasibility of reaching your financial goals if you choose to invest all your money in such investments. Some disciplined exposure to equity is warranted, especially for long term goals.

Now to the guaranteed products I am not comfortable with.

Non-participating traditional life insurance plans offer guaranteed returns. With such plans, everything is known upfront. You know how much you will pay and how much you will get and at what time. The non-participating plans offer about 4-5% p.a. annual returns (even lower than participating plans). Not exciting. Since the proceeds are likely exempt from tax, the post-tax returns are likely in the same range as a bank FD (if you are in the highest tax bracket). However, the problem is you are not really told about the true returns when you bought the products. You just focus on the cashflow numbers and the numbers can fool you.

Then, there are participating traditional life insurance plans that are pitched in a manner that gives an illusion of guarantee of returns. Now, such plans can’t give guaranteed returns. Your returns depend on the reversionary bonuses, loyalty benefits and terminal/final additional bonus, which can’t possibly be calculated in advance. However, the prospects are given the impression that the returns are guaranteed. Moreover, you only focus on the cashflows and the returns.

And a few more.

Irrespective of the past experience, we tend to reach for the higher yields or returns. That explains the lure of corporate fixed deposits or Non-convertible debentures (NCD). Most of us don’t appreciate the risk involved with such Corporate FDs/NCDs until it hits us in our face. Ask those who held fixed deposits or NCD issued by DHFL. I am not saying that all such issues are bad. At the same time, you must appreciate higher returns come with higher risk.

I am not talking about ponzi or other fraudulent schemes where abnormally high and guaranteed returns are offered. You invite disaster if you invest in such schemes.

What is the price you pay?

Investing only in guaranteed returns products will likely have an impact on your long-term wealth.

At 6% p.a., Rs 10 lacs grows to ~ Rs 32 lacs over 20 years.

At 8% p.a., Rs 10 lacs grows to ~ Rs 46 lacs over 20 years.

At 10% p.a., Rs 10 lacs grows to ~ 67 lacs over 20 years.

At 12% p.a., Rs 10 lacs grows to ~ Rs. 96 lacs over 20 years.

That’s the power of compounding in full flow. You can see the difference a couple of percentage points can make.

A lower return also requires you to make invest more.

To accumulate Rs 50 lacs in 20 years, you need to invest ~Rs 10,973 per month at 6% p.a.

To accumulate Rs 50 lacs in 20 years, you need to invest ~ Rs 8,731 per month at 8% p.a.

To accumulate Rs 50 lacs in 20 years, you need to invest ~ Rs 6,906 per month at 10% p.a.

To accumulate Rs 50 lacs in 20 years, you need to invest ~ Rs 5,435 per month at 12% p.a.

At the same time, if you just can’t live with volatility, either seek professional advice. Or simply stick with guaranteed return products. You will do yourself greater harm if you move in and out of volatile assets out of fear, greed or sheer impatience. 5% return is better than -5%.

Read: How to invest if you have a low risk appetite?

By the way, the guaranteed return products do not always offer low returns. For instance, annuity plans provide a return guarantee too and can still provide a very high rate of return. I have written about how annuity plans can be an excellent source of income during retirement if you purchase the right variant at the right age. Therefore, not all guarantees are bad. For more on what are annuity plans and how you can use them in your portfolios, refer to these posts. Post 1 Post 2

Awareness about Risk and Returns is extremely important

If you are buying a low return product and you know that it is a low return product, it is OK.

If you are buying a low return product but you DON’T know it is a low return product, it is NOT OK.

You must understand what you are getting into.

If you make a risky investment knowing that it is a risky investment, it is OK.

If you make a risky investment believing it is a safe investment, it is NOT OK.

This awareness will help you make the right decision about the allocation to risky investments. For instance, if you thought that X investment offers high returns and is super safe, you won’t mind putting say 50% of your investments in such an investment. You won’t see much utility in diversifying your investments.

However, if you thought you can lose money in X investment, you will perhaps not want to invest more than 5-10% in X. Appreciation of risk makes you alive to the possibility of unexpected or unwanted things happening. You start seeing the merit in diversification.

If you could pick up a multi-bagger stock every time, you wouldn’t need to have a portfolio that is more than a couple of stocks. However, if you appreciate that things can go wrong, you would perhaps consider a wider portfolio of stocks or even a mutual fund.