I believe the simplest way to start investing is with a cheap and easy mix of cash and an index tracker.
You’ll have seen the adverts:
Invest in the Filchet and Philander Guaranteed Equity Bond Issue Mark 4! Your capital is not at risk (unless the stock market drops by 32.5% between August 13th 2012 and January 22nd 2014) and after five years you’ll get 33% of the gain in the FTSE 100 index (unless it’s up over 75%, in which case you’ll get the 2/3 of any gain over 21% plus half the number you first thought of). You can cash in your bond-thingie at any time, provided it’s a third Friday of either April or October on every odd year from the day you bought the bond.
I exaggerate, but you get the picture. I don’t like these guaranteed equity bonds (GEBs) for many reasons:
- They’re opaque – The average person doesn’t know how they work, or why.
- They’re a lie – ‘Guaranteed’, ‘equity’, and ‘bond’: Words chosen to reassure widows and the guardians of orphans, but these products are actually constructed out of derivatives and options! Hence the weird hurdles like ‘the FTSE must be over 5223 on such a day’, as well as extra counter-party risks.
- They’re confusing – While some of these so-called bonds may offer a good balance of risk versus reward, they’re invariably sold to people who couldn’t tell. In fact, I’ve never met a guaranteed equity bond owner who can explain to me what they’ll get under what circumstances.
- They’re expensive – Not just in terms of the gains you give up for potential security of capital (which may be fair enough) but also the hidden fees rolled into their arcane structure.
- They’re inherently flawed – Most give you a return based on the value of the stock market on some particular day, or if you’re lucky over the average of a few months. But stock markets are volatile, so ill-suited to this. Buying a product where the return is dependent on the level of the index over a few days in five years time is like choosing a spouse based on what you think you’ll get for Valentine’s Day in 2017. You might have five good years followed by a week long crash, yet still be forced to cash out.
People are drawn to these bonds, though, and it’d be arrogant of me to dismiss that. The urge for capital protection is strong, rightly or wrongly.
And when it’s money someone may get just once in his or her lifetime – perhaps an inheritance, or a redundancy payout – who am I to tell them they should be braver with the stock market?
Instead, I’ll tell you a neat way to get capital protection, while still getting the chance to make money from a rising stock market.
How to roll your own Guaranteed Equity Bond
What I’m going to suggest isn’t rocket science.
Guaranteed equity bonds promise to return the sum of money you put into them (ignoring inflation). But you can use cash savings and a stock market tracker fund – plus a calculator – to create the equivalent of a guaranteed equity bond, provided you’re not investing vast amounts of money.1
Your DIY guaranteed equity bond consists of two parts:
Part A: Sufficient cash in a fixed rate savings ISA
This is the component that guarantees you get your capital back. Out of your lump sum investment, you put enough cash into the ISA so that when the compound interest is rolled up you’re left with the same lump sum that you started with.
Part B: Invest the rest in an index fund
The money left over goes into a stock market index fund. Whatever the stock market does over the period, that’s your return on your lump sum.
A worked example
Let’s say you have £5,000 to invest for five years. The two steps are:
- Part A – Work out how much of the £5,000 to save as cash
- Part B – Invest whatever is leftover from that in the stock market
Part A: The cash component
Suppose the best five-year fixed ISA savings rate you can find pays 5%.
You can either use maths to work out how much you’ll need to put aside in cash to ensure you have £5,000 left at the end, or you can do what I’d do and simply play with the Monevator compound interest calculator to find the right amount by guesswork:
In this example, the number of years is “5”, the amount added each year is “0”, and the interest rate is “5”. Put your guesses into ‘Initial Amount’ until the Result is £5,000. (If Result is more than £5K, lower the initial amount, and if it’s less than £5K, raise it until it’s as close as can be).
Through trial and error you should soon find that an initial sum of £3,918 saved at 5% will give you £5,000 (and 14p) in five years time.
That is your part A. You put £3,918 into the ISA and let it compound for five years, and get your £5,000 back in five years time.
Part B: Investing the rest in a tracker fund
The leftover money that you don’t need to save as cash – £1,082 in this example – goes into part B, a stock market index fund.
You want to choose the cheapest index fund you can find to keep costs ultra-low. Your best bet as I write would probably be the HSBC All-Share Index Fund, which has no initial fee and charges just 0.27% a year.
Choose the accumulation option so you automatically reinvest the 3% or so in dividends you’re due back into the fund each year.
Returns from the DIY pseudo-GEB
Here’s a few examples of how your returns could pan out, depending on how the stock market performs over the five-year period.
|Market return* after five years:||-30%||0%||30%||50%||100%|
|Cash component after five years||£5,000||£5,000||£5,000||£5,000||£5,000|
|Equity component after five years||£757||£1,082||£1,407||£1,623||£2,164|
|Total value of your DIY ‘bond’||£5,757||£6,082||£6,407||£6,623||£7,164|
|Gain** on your initial £5,000||15%||21.5%||28.5%||32.5%||43.5%|
- From looking at the table, you can see in my worst case scenario, where the market is 30% down after five years, you still make a gain on your lump sum.
- In fact, if the market was completely wiped out and your index fund went to zero, you’d still get your £5,000 back (assuming banks were still standing!)
- On the other hand, when the stock market (plus dividends) doubles, you make less than half that rise with a 43.5% gain. The cash is a drag on your returns.
This latter point illustrates the price of security. In fact, you need your index fund to make at least 30% over five years for your returns to be better than leaving all your money in cash.2
But at least this way you do get exposure to potential big gains in the stock market, without risking a nominal loss.
Benefits of this ‘DIY’ Guaranteed Equity Bond
I’m not claiming this cash-and-index combo will deliver better returns than every GEB going. That’s not why I’m suggesting it here.
Rather, I’m putting it forward for the following advantages:
- Simple to understand – Everyone knows what a cash savings account is, and an index tracker fund is as simple as stock market investing gets.
- Cheap – Savings accounts are free, and tracker funds are the cheapest way to invest in a diversified basket of shares.
- Transparent – You can see exactly how much money you’ve got at any time. There’s no hurdles or precipices – if the market drops your fund will go down, and vice-versa.
- You’re in control – You don’t have to sell out of your tracker fund after exactly five years if the market is in a slump. You can wait for a better opportunity. Equally, if the market goes up very quickly in the first year or two then you can take some money off the table if you choose. You get nothing like this hands-on choice with a standard GEB.
I’ll have more thoughts on this DIY guaranteed equity bond in part two, such as how you can modify it to take slightly more risk for more reward. I’ve closed comments for this article, so we can have all the discussion about the pros and cons in one place when the piece is concluded.