2.8 Huge risks / big rewards

Shackleton knew about risk and reward
Shackleton knew about risk and reward

Chapter Overview
Risk = Reward

Another self-explanatory chapter but with a couple of references which are worthy of investigation.

Structured Notes

Wikipedia defines it as: “A hybrid security that includes several financial products, typically a stock or bond plus a derivative. A simple example would be a five-year bond tied together with an option contract. The addition of the option contract changes the security’s risk/return profile to make it more tailored to an investor’s comfort zone. This makes it possible to invest in an asset class that would otherwise be considered too risky.

The book says the benefits of structured notes are pretty much that – participating in some of the upside of an investment while limiting the risk or downside.

It certainly looks like they’re out there too.  This Money.co.uk page lists a handful of deals.  I know the book circles back later to deal with this again, so I’ll investigate in detail then!

Market-Linked CD’s and FDIC insurance

The book says that Market-linked Certificates of Deposit are similar to structured notes except that they are insurance-backed by the Federal Deposit Insurance Corporation (FDIC).

The UK equivalent is The Financial Services Compensation Scheme (FSCS) which provides capital protection of £85K  for sole accounts, or £170K for joint ones.

Looking at that previous link about structured notes, all of them have FSCS protection – which seems like an essential component of protecting the risk of loss of capital – the entire point of this kind of an investment.

As with all FSCS protection, it applies to the institution, not the investment.  So, for example, if you had a number of different investments with (let’s say) Barclays totalling over £85K and Barclays went bust, you’d only get £85K back from the FSCS.

It’s worth bearing in mind that for full FSCS protection above £85K, the investments need to be with different institutions.  You can check which institution the FSCS guarantee applies to before making the investment – and it’s not always obvious.

For example, I know that Santander Bank now own Cater Allen Bank – but the FSCS generally applies to all Santander brands, not to Cater Allen.

Here’s a useful, Who owns whom? article.

Fixed Indexed Annuities

Not to be confused with Indexed or Index-linked Annuities. A google search mostly delivers results about the latter type – which are plain old vanilla annuities but index-linked to increase with inflation.

Fixed Indexed Annuities are linked to a stock market index and are also known as equity-indexed annuities and hybrid annuity. Here’s a good article explaining their pros and cons.

Basically, a fixed indexed annuity looks similar to a structured note except that some growth is also protected – compared to the structured note where only the capital is protected.

On the flip-side, the actual amount of growth is capped compared to a structured note.  So while you may be able to lock-in some of the growth AND protect the capital with a fixed indexed annuity – that growth (all other things being equal) is likely to be lower than with an equivalent structured note.

All this is probably academic because I couldn’t find any UK providers of these kind of annuities.