In summary: My proposed DIY GEB is cheap, transparent, safe, and flexible. In contrast the GEBs flogged by banks and advisers are opaque, potentially expensive, and built around derivatives.
Today’s post offers some follow-up ideas, so please do read the original DIY Guaranteed Equity Bond article first.
Haven’t you been too cautious?
Yes, deliberately so.
My proposed DIY GEB returns your full capital after five years — even if the stock market goes to zero – due to you keep enough money in cash to guarantee it.
But the stock market is unlikely to go to zero. And if it did, I doubt you’d be able to retrieve your cash, or find shops to spend it in.
I deliberately kept things simple and 100% secure for the introduction, but there’s a way to tweak the risk to your own taste:
- Work out how much you need to split your lump sum between cash and the stock market tracker to guarantee capital protection, as detailed in part one.
- Decide the worst-case return you think is likely from the stock market over five years (remember to include dividends, at around 3% a year for the FTSE All-Share).
- Apply your worst-case return to your stock market allocation, to see what your tracker would be worth in five years if the stock market did that badly.
- Since in your worst case you expect your tracker fund to be worth whatever number you just worked out, you can subtract that from your cash savings target after five years.
- Recalculate the (lower) amount you need to put into cash to aim to get to no loss of capital after five years when incorporating the stock market returns, and put the (now higher) amount of spare money into your stock market tracker.
Confused? You can see why I left it out of the introduction!
A riskier GEB: A worked example
Some numbers should make it easier to understand (and also show how it is a fudge).
From part one’s example of a £5,000 lump sum, we worked out we needed to save £3,918 in cash at 5% in a tax-free ISA for five years to ensure we still had £5,000 at the end.
The rest, £1,082 went into the stock market. If that went to zero, we’d still have £5,000 due to the cash.
But let’s say in our worst-case scenario, we think that after reinvested dividends of c. 3% per year, the money in the tracker fund won’t fall by more than one half over five years.
- One half of £1,082 is £541.
- So our new cash target after five years is (£5,000-£541) = £4,459.
Playing around with the compound interest calculator shows we need to save £3,492 at 5% in the cash ISA to ensure we get £5,000 back from adding together our new cash target (£4,459), and our worst case stock market return (£541).
This gives us a higher £1,508 to invest in the stock market tracker fund – some 50% more than before — and so capture more reward if the stock market rises.
Caveats and catches
Anyone of a mathematical bent will appreciate that half of £1,508 is actually more than £541. Hence in our worst case of a 50% return for stocks, we’d actually have more money then we need.
If you suspect we could therefore repeat the above process of recalculating the cash amount required over and over for diminishing gain every time, you’re right.
There’s probably an equation I’ve forgotten from my A-Levels that can work it out recursively, or maybe you could write a quick computer program. But personally, I’d do it just once, then consider the surplus cash a margin of safety on the stock market doing even worse than you think possible.
On that note, this riskier DIY GEB is no longer capital guaranteed, because stocks could do worse than you can imagine. But GEBs created by the banks also fail in certain circumstances, so the riskier DIY GEB is no worse.
Also – and crucially – you’re not forced to sell out after five years with the DIY GEB if you find you’re stuck in a bear market in year five. You can wait. In a conventional GEB, you’d have to follow whatever rules you signed up to when your time was up.
What’s a safe worst-case scenario? Well, 50% is the biggest minimum return I’d predict, just to be on the safe side. I’m pretty sure 30% would cover all historical eventualities, but I haven’t worked it out.
A few more FAQ-style thoughts
In the process of inventing this DIY GEB (though I’m sure I’m not really the first to think of it) I asked myself some questions, which I’ll answer now.
Hopefully I cover most queries, but please do post your thoughts in the comments below.
Where can I get a 5% fixed rate ISA?
At the time of writing, you can’t. Use whatever ISA rate you can get. I fully expect to see rates well above 5% in the fullness of time, too.
Why does the cash have to be in an ISA?
I’m assuming a tax-free return, to keep the maths simple and the DIY GEB feasible. If you have say £50,000 to invest you could do a similar thing using cash savings outside of an ISA, and a (lower) net savings rate. When interest rates return to normal higher levels this might be attractive, but currently you’re not going to have much money left spare for the stock market.
Why not use gilts instead of cash?
You could do this, particularly when gilts are actually offering a decent yield. In fact, gilts are ideally suited to the fixed time horizon aspect of the DIY GEB. You could buy a five-year gilt, say, locking in a running yield as the gilts move to redemption. However, there’s one big flaw to gilts, which is that you can’t re-invest your gilt income without paying a dealing fee, like you can with cash interest, and you’ll likely be limited to minimum deal sizes, too. If you’re that investor with £100,000 to make into a DIY GEB, gilts may be worth exploring though, especially when the yields are higher.
Why not use corporate bonds / prefs / offshore bonds, etc?
These securities sometimes offer higher income (so letting you put more in stocks) but they’re not risk-free like cash, or even nearly risk-free gilts. Feel free to experiment with weird and wonderful fixed interest / stock market fund combos, but understand you’ll be taking on far more risk as you do so. (At least you’ll be able to see the risk, mind, compared to a bank’s GEB).
I think the Snodgrass and Bunderberry GEB is a better bet!
No doubt it is. I’m not saying my proposed DIY GEB is going to make you more money than a bank’s GEB. I’m saying it’s more transparent, flexible, and likely cheaper. It’s your choice.
What about inflation?
Quite right — £5,000 today is worth more than £5,000 in five years after inflation is taken into account. But that’s exactly the same with a bank’s GEB. I’m only offering an alternative to their capital guaranteed product. I’m not saying that guarantee isn’t an illusion, given inflation and the time value of money – it sort of is!
Isn’t it all a bit fiddly?
Are you following this strategy?
Not on your nelly! Again, I think it’s better to stomach a bit of volatility in my net worth, which at the time of writing is largely in the stock market. But for people who are tempted by a guaranteed equity bond for the capital security but who rightly wonder what on earth they’re buying, the DIY GEB at least provides a simple and cheap alternative that leaves you in control.
I locked comments in the first article to keep everything in one place, so please do let me know what you think below (especially if I’ve made any maths mistakes! 😉 )