FINANCIAL PLANNING FIB #2

This is a good investment because it's capital protected

Whoever came up with the phrase 'capital protected' should be given a marketing achievement award by the finance industry. It works like a magic bullet in sales presentations.

For many commission-based planners, selling financial products is a process of building up the list of advantages until the client is ready to sign on the dotted line. For relatively simple products, like cash management trusts, pointing out the high interest rate and well-known corporate brand will probably do the trick.

But for complex products, clients generally need more convincing and that's where 'capital protected' comes to the rescue. When a planner is explaining how limited recourse loan facilities and knockout events work, most clients' eyes are probably glazing over but the mood nearly always lightens when they hear that their capital is protected.

Fund managers have also realised that 'capital protected' is a sales clincher and the range of products with some form of capital protection has exploded during the last decade.

But there are two things to be wary of when you hear this phrase.

The first is that no company is going to take on someone else's financial risk without being handsomely compensated for doing so. If there is a genuine risk of financial loss, you can be sure that the capital protection feature is not going to come cheaply and that the terms will not be in your favour. In many cases, the company offering the capital protection is just taking the opportunity to sell you two financial products instead of one. Namely, an equity portfolio plus a put option or an equity portfolio plus a loan.

The second is that nowadays capital protection is being used to promote products where there is little or no risk of a capital loss anyway. For example, there are a number of equity products which claim to be capital protected at maturity, which is typically in six to eight years' time. But such guarantees are really just an advertising gimmick. That's because the risk of a share portfolio being below its original cost after six years is just 0.2% (i.e. a one in five hundred chance) and after eight years the risk is zero.

So when you hear capital protection offered as a good reason to invest, be alert. Often it has more to do with boosting the fund manager's income rather than protecting your capital.

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