When you hear, Its guaranteed, what do you think of? Safety, reliability or predictability? Certainly these can all describe a guarantee.
However, another side to any guarantee often isnt immediately visible. A guarantee always includes fine print, the conditions under which it will be honored. It alsoes with a cost: a higher price, lower return, less opportunity, loss of freedom ormitment.
The Cost of a Guarantee
Apany selling a product with a guarantee is taking a bet that either the item wont break or you wont file a claim when it does. To cover its risk, thepany sells the product at a higher price.
The insurance industry operates on this principle, as well. You pay premiums to them in exchange for a guarantee of payment in case of a loss or expense. They bet against you, hoping the catastrophe they are insuring you against never happens while the policy is in force.
The concept is the same with investments. Any time you put money into a product that guarantees you wont lose money, guarantees a certain return or puts a floor under your potential losses, you are paying a premium of some type.
How Guarantees Work
Take a certificate of deposit (CD). This is money you loan to a bank for a set period of time. The bank agrees to pay rent for use of your money (the interest rate) and guarantees you wont lose a dime.
What is the cost of the guarantee? On a CD, its the difference between the interest rate you receive from the bank and the rate you would receive from a large corporation with a high credit rating. For example, the recent Bankrate national average on a five-year CD is 2.27 percent. Conversely, if you purchased a five-year corporate bond with an AAA rating, with no guarantee of repayment, you would earn about 5 percent.
To assess your risk of making the non-guaranteed investment, you would want to find out what percent of loans are made to corporations with AAA ratings default. That figure is about one-half of 1 percent. The cost of insuring against an event that has less than a 1 percent chance of happening will cost you 60 percent of the return. This would appear to be a very costly premium.
Is a Guarantee Worth It?
Sometimes paying for guarantees makes good sense, such as buying auto, home and liability insurance. In certain circumstances, a guaranteed but low-return investment like a CD might be the best place for some of your savings.
At other times, paying extra for a guarantee is a waste of money. An example might be buying an extended warranty on an appliance thats unlikely to need service. Some types of insurance guarantees (flood insurance in New Orleans, anyone?) require such high premiums that they rarely make sense.
Next time you hear Its guaranteed, dont think only in terms of reliability, safety and predictability. A guarantee may well indicate all those qualities. But those two words alwayse with a price tag, as well. And thats guaranteed.
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