Guarantee! तेरा इश्क़ मुझे ले डूबा

(teraa ishq mujhe le doobaa)

With scenic mountains and deep gorgeous forests, Jatinga is a beautiful village in Assam. However, this quaint village attracts tourists not because of its beauty but for its reputation as a “valley of death”. Yes, you read that right: every year, from September to November, thousands of birds get attracted to fire and end up killing themselves at Jatinga.

Homer, in his epic poem “The Odyssey”, tells the story of the Sirens. These winged monsters would appear as beautiful women with part-bird and part-human features. They would lure passing sailors with their enchanting songs, and those who were hypnotised by these songs would eventually have their ships wrecked.

Christopher Marlowe's classical drama “Doctor Faustus” narrates the story of an unequalled genius of his time, who gets so carried away with his quest for knowledge that he agrees to sell his soul to the devil. According to the contract, for 24 years, Dr Faustus would achieve whatever he desired, but after the end of that tenure, he would have to serve in hell for eternity.

Credit: The Devil and Dr. Faustus meet. Wellcome Collection. Attribution 4.0 International (CC BY 4.0)

Each of these situations involves an irrational mind whose infatuation eventually becomes the reason for its collapse.

The Merriam-Webster dictionary defines ‘infatuation’ as: “a feeling of foolish or obsessively strong love, admiration, unreasoning attachment or interest for someone or something”.

The birds getting madly attracted towards fire; ancient Greek sailors getting mesmerised by the Sirens; the unending desire of Dr Faustus: all of these portray the fallacies of a mind whose irrational desire for something is so strong that the same longing eventually became the reason for its downfall.

This brings me to an interesting analogy when it comes to personal finance. As investors, most of us are so in love with products that come with a guaranteed feature that we fail to properly evaluate the various other aspects associated with them.

But should a guarantee be the only reason for us to invest?

To create wealth, we need to ask relevant questions to ourselves and to those who help us buy these “guaranteed” products.

So the next time someone tries to sell you a product with a guarantee, you should be more interested in knowing what percentage of return is guaranteed.

There is a high chance that the answer will be in the vicinity of the current return rates of government bonds.

So the conclusion is that our return is guaranteed only to the extent that government bonds allow, maybe a percentage point higher. It will never be absurdly high and yet guaranteed.

However, suppose the answer to the above question is significantly higher than the current government bond return rate. In that case, the next thing one needs to look at is, the method of generating the additional return over government bonds of similar maturity. 

For example, suppose India's current 10-year government bond (g-sec) offers 7%, and someone quotes 10% as a guaranteed rate. In that case, I need to doubt the claim with a similar risk parameter. This is because most instruments with a guarantee and with good credit quality will tend to hover near the g-sec rate of similar maturity. For instance, going by the 10-year historical average, 3-year corporate bonds offer 0.82% more than government bonds of the same maturity.

Take, for example, the following WhatsApp forward I received recently:

If you are among those rare people who didn’t get carried away by the two magical terms in the entire advertisement, give yourself a pat on the back. But if ‘10.5%’ and ’Guaranteed’  tempted you, do smile, as you are perfectly normal.

Most of us will read the advertisement in its entirety but will focus only on the part about ‘10.5%’  and ‘Guaranteed’.

Now let’s read it again and analyse the factual information available in this forward.

It says, “Invest Rs 12.47 Lacs once for 15 years & Get Rs 1,32,500 every year for LIFETIME from 16^th year.”

So the question to be asked is: what will happen to the interest accrued during the first 15 years?

Additionally, the value of Rs 1,32,500 in the 16th year would be a mere Rs 63,735 of today’s money, and would continue losing its value every year even after that.

With this understanding, when we recalculate the actual interest rate, it will be meaningfully lower than what it seems to be at first glance.

One may argue about the additional feature of lifetime coverage, but for that, there are other low-cost insurance products available in the market. In fact, term insurance and health insurance are basic requirements for everyone. Still, the reason for buying any insurance product should solely be the insurance coverage, and never the returns.

Now, if those telling us about guaranteed returns agree that the return rates will actually be close to government security rates, the next question to be asked is:

How will my investment beat inflation and help me generate a positive real rate of return?

At this point, you’re probably saying: “Hey, hold on: inflation, real rate… all this sounds like economic jargon to me. Please simplify”.

Let's make an attempt:

Inflation

Simply put, inflation is the decrease in the purchasing power of the money we hold. For example, if we had spent Rs 50 to buy a movie ticket 20 years ago, now to buy the same movie ticket, we will have to spend close to Rs 350. The value of the money we held 20 years ago has decreased over time, and hence to acquire the same benefit, we have to spend more.

Inflation sucks up the value of your money.

The RBI tries to maintain an inflation rate of 4-6%; hence, for long-term calculations, we often use 5% as the standard inflation rate in India. 

However, the inflation rate of various goods and services we consume is much higher than the standard rate we use for calculations. Health-related expenses, for instance, in India are rising at 15% and schooling expenses at 10%. At a 15% inflation rate, a current expenditure of Rs 1,00,000 will cost us Rs 1,15,000 next year, Rs 1,32,250 the year after that, and so on.

Looking at the inflation rate of the most common goods and services we consume, we can infer that our portfolio needs to generate a higher return rate than the inflation rate.

Real Rate

Investopedia defines the real rate as an interest rate that has been adjusted to remove the effects of inflation.

For example, if my portfolio generates a return of 7% and the combined inflation rate of all the goods and services I consume turns out to be 8%, then I am getting a negative real rate (7% returns minus 8% inflation = negative 1%).

In other words, inflation is gobbling up my returns, so my purchasing power will decrease every year. As a result of this, I will have to compromise on my future lifestyle.

Read that last statement again!

On the other hand, if my portfolio could generate a return of 10% and the current inflation rate is 8%, I would make a positive real rate of 2%. This means my portfolio is earning 2% more every year even after the impact of inflation, and hence is growing in a real sense.

Sounds good, but how do I add the additional 2% to my portfolio?

It’s by not investing all my funds in guaranteed instruments and by adding equities through mutual funds to my portfolio. We don’t intend to replace all our conventional products with equities. But they have to be a part of your portfolio so that you get that additional 2-3%.

But the biggest reason many investors tend to avoid mutual funds is that the returns are market-linked and not guaranteed. 

Now, what is market-linked?

It means the returns are decided by the market based on existing circumstances.

However, in the real world, what holds significance is our understanding of the concept of the probability of any event occurring. This can be as basic as the probability of whether my spouse will serve me aloo-paratha or sandwich this Sunday during breakfast, or something more complicated, like the chances of India winning the next T20 world cup, or the probability of me accumulating one billion dollars in the next 20 years.

While calculating probabilities, one key factor is the number of occurrences of a similar event in the past. For example, if my spouse served me aloo-paratha on 6 out of the last 8 Sundays, I might expect a higher chance of relishing aloo-paratha next Sunday as well.

Along the same lines, since 1997, no investment in equities has generated negative returns if invested for 10 years in NIFTY 50 TRI. So the chance of making negative returns from equities over a 10-year period is extremely low. In fact, in 96.2% of cases, it has delivered a return of higher than 8%.

Apart from the factors highlighted above, the post-tax return is another noteworthy aspect to remember when dealing with “guaranteed” products. The returns earned from these investments are taxed as per the personal tax slabs, and hence, the actual returns get significantly dented compared to what they seem to be at first glance.

Lastly, the inability to get out of any “guaranteed” return-generating product before maturity without paying a penalty must also be kept in mind. This may lead investors to a psychological behaviour called ‘sunk cost fallacy’, where someone keeps on investing even after realising that the initial investment decision was faulty to ensure that he does not lose what has already been invested. However, a deeper analysis in most cases reveals that the decision to stay back to recover the initial loss results in a more significant loss at a later stage. 

An investor who didn’t fall prey to the sunk cost fallacy.

Swiss author Rolf Dobelli explains this concept as follows: “Rational decision-making requires you to forget about the costs incurred to date. No matter how much you have already invested, only your assessment of the future costs and benefits counts.”

So instead of getting carried away by guarantees, we need to be careful when evaluating products, because if we make a mistake and realise it later, exiting an investment may be difficult without paying a substantial penalty.

This is however easier said than done, and what complicates it further is the availability of a wide range of products, making it even more difficult for us to choose what is best suited for our requirements. This is why it’s important to consult your financial advisor before making any decision, as they are better equipped to guide us on this subject.

In the meantime, always keep in mind that:

Guaranteed products are subject to inflationary risk. Read all features carefully before investing.