I previously explained how to create your own Guaranteed Equity Bond (GEB) using a cash savings account and a cheap FTSE index tracker fund. I also outlined why you might want to.
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?
Absolutely. I personally suggest new investors simply split their savings between cash and a stock market index fund, and get used to capital fluctuations as the price of higher returns.
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! 😉 )
Comments on this entry are closed.
I think this is actually a pretty brilliant strategy for a new investor as the cash section of your DIY GEB can also act as that classic PF stalwart the emergency fund. Although most of my financial instrument savings are in stocks of various formas I started pretty much along these lines with two years cash ISAs lumped together as well as starting my shares ISA with half the cash in the second year.
Particularly at the start of one’s savings career after icing mortgage debt, you need that cash lump to avoid unexpected expenses killing your strategy off or making you do a forced sale into the stockmarket which is never good.
If they were still available then N&SI index linked bonds would be a good alternative to the Cash ISA and for the wealthier also leave more space for the shares part. My plan was to establish a rolling three-year ladder of these equal to my cash ISA and then migrate my cash ISA into my shares ISA – you are allowed to do it that way but not the other way, so your GEB idea also has that nice future flexibility to it.
Maybe you ought to market it as the Bank of Monevator Guaranteed Income Bond with extra flexibility and take a nice fat fee 😉
.-= ermine on: sharesave schemes and hedging losses and house price deposits using spread betting =-.
Any chance for an American Interpretation?
.-= Evan on: Creating a New Alternative Stream of Income–My First Non-Blog Website Part I =-.
You might be interested in the following article: It’s US-focused but could, I think, be tailored to investors almost anywhere via interesting new services like LMAX ( http://www.lmaxtrader.co.uk/ – also worth checking out)
Check it out: http://moneywatch.bnet.com/investing/blog/irrational-investor/build-your-own-annuity/1879/
All the best, Baxter
One useful application of the DIY GEB is when you have enough capital to pay off a loan in a certain timeframe, yet choose not to because you don’t wish to be cash poor. So a guaranteed return of the capital at the end of the specified period with a shot at early payoff would be handy.
I think these two articles are some of your best for a long time. You’ve skewered a dodgy financial product and shown people how to build their own (cheap!) alternative. The fact is that many people are not as tolerant of swings in their investments as you and so your DIY GEB could help quite a few people. It would be a good vehicle for saving for a deposit for a house, for example: there is the security that its nominal value will not fall but also potential for reasonable growth if the economy takes off.
And as for 5% ISAs, you’re right that there aren’t any yet, but you can get 4.25% fixed for five years from Birmingham Midshires (part of Lloyds Banking Group), Halifax (ditto) and Bank of Scotland (ditto).
Many years ago, I worked on one of these “things” for a bank (as an IT nerd rather than a financial adviser). It was unbelievably complex and was obviously designed to maximise the bank’s profits (don’t know why I should have been surprised!) i.e. they retained the dividends, capped the maximum payout to customers (retaining any surplus), used derivatives to “de-risk” the guaranteed payout and imposed draconian penalties for any customer that dared asked for their own money back (whatever the change in circumstances).
I’ve just checked a couple of bank websites: little has changed with product design, although (thanks to the FSA?), the poor terms and conditions of the products seem reasonably clear; so well done for proposing a DIY alternative for those that need the security, without all the disadvantages of a packaged product.
Thanks for the thoughts guys, and glad you found it useful. I was particularly pleased to hear your comment Tony, as a former insider! 😉
@Evan: I suppose the US equivalent would be to get a 5-year CD and put the remaining money into a S&P 500 index fund. I don’t know what bank interest rates are like over the pond but I do know that you have cheaper index trackers! (And the FDIC covers larger deposits than the UK deposit insurance scheme.)
@Nicklas @Evan – The annuity post suggested above also suggests a similar thing. Great minds think alike, even when one is in America! 😉
“There’s probably an equation ….. that can work it out recursively …..”
I ran a spreadsheet simulation with realistic parameters, and it needed 8 iterations to reach the ultimate 50% point.
” ….. or maybe you could write a quick computer program.”
If there actually is an “equation” then it’s outside the scope of my humble maths but, yes, with a modicum of ingenuity I’ve cranked out a spreadsheet program which gets to the ultimate 50% end-game in a single shot, after the input of the FI interest rate and the time horizon.
FYI, the motivation for the spreadsheet program came from the earlier speadsheet simulation.
Good stuff Topman!
Tks Investor. The part-time product of some days half-terming in the far west of Cornwall, with don’t mess with me Atlantic rollers crashing onto the beach 100 yards away in a force 8!
“….. this riskier DIY GEB is no longer guaranteed …..”
So instead I shall personally call it a PEB, i.e. protected instead of guaranteed, and be putting it to immediate practical use (incorporating the output from my full “iterated” 50% calculator).
Suppose you have a risky asset which you estimate to have worst-case growth r, and a safe asset with growth rate s.
We want to find the proportion P which should be assigned to the safe asset in order to ensure that you get your initial capital back in the worst case.
This means that the proportion assigned to the risky asset will be (1-P), so the total multiplier over n years is:
P(1+s)^n + (1-P)(1+r)^n
We want to ensure that the worst-case r gives us growth of 0%, i.e. a multiplier of 100%. So we just set the above expression to be equal to 1.
P(1+s)^n + (1-P)(1+r)^n = 1
Let’s simplify that a bit by defining S = (1+s)^n and R = (1+r)^n
PS + (1-P)R = 1
Rearrange a bit and you get a formula for P, the proportion to assign to the safe asset:
P = (R-1) / (R-S)
Forgot to add; if you want to take inflation into account, just correct your initial growth values r and s for expected inflation in the usual manner. 🙂