Tuesday, June 21, 2005

There Are No Guarantees & The Future is Impossible to Predict

Every time I turn around these days I see old financial products and new financial products being hawked by using the most emotional word in the english lexicon "Guarantee." As if by saying the word guarantee it makes it so. The fact of the matter is that guarantees don't really exist. A guarantee implies no risk, if you doubt that I challenge you to type "no-risk guarantee" into google.

If I say that there is no such thing as a guarantee when it comes to financial products, why is it that we always see this term used? It is used because marketers know that it gives their prospective buyers a "warm fuzzy" when they hear the word - it makes them feel safe and protected. To most people what is being guaranteed and what they think is guaranteed are two different things.

The most important concept in money is purchasing power, yet most people have no idea of what it means. Purchasing power refers to the amount of goods and services an individual can buy at any given moment in time. An example of a guarantee not actually being a guarantee is with insurance companies who issue immediate annuities. An immediate annuity is basically an income stream that you can't outlive. You hand the insurance company some money and they hand you a monthly check till you die, guaranteed.

Sure the monthly check is guaranteed by the insurance company, but what if they go out of business? The state will most likely come in and rescue you, thereby making you whole, but what if the state doesn't have the money to rescue you and what if the federal government refuses to rescue you - your income is gone, it's not really guaranteed. Of course, the likelihood of these events happening are small, but that doesn't mean they won't happen. More importanly however is that the guaranteed income stream provided by the insurance company isn't really what you thought you were purchasing, thus who cares about the guarantee. What good is an income stream if it doesn't buy you anything? Have I lost you yet?

Let me give you an example. Say you gave an insurance company $100,000 today and in exchange they will pay you $500 per month for the rest of your life. Today, that $500 buys you groceries for two months, no problem. However, ten years from now the $500 monthly income stream will only buy you 1.5 months of groceries. Twenty years from now the income stream will only purchase you 1 month of groceries.....half of what the money bought you the day you started. Thirty years from now your $500 will buy you about three weeks worth of groceries....better make them last. The point is that though you thought you were buying a guaranteed income that would buy you the same amount of goods and services each year, in reality you were simply buying $500 dollars a month in advance for the rest of your life, the fact that the $500 buys you less and less each month was not part of the sales pitch and "purchasing power guarantee" was never mentioned.

The same goes for government bonds. They are safe in that you will never lose your dollars, but if your dollars buy you less and less YOU ARE LOSING MONEY. A guaranteed return of dollars is different from a guaranteed return of purchasing power and purchasing power is what you should be focusing on.

Given that nobody can consistently predict the future there are no scenarios in which a guarantee can really be called a guarantee, of course this is mostly sematics. My point is that you should ignore the snake oil salesman who tout "guarantees" as a way to sell their products, they do so because they know that their product is so weak it can't be sold unles it is guaranteed (Think Hyundai's ten years ago). Forget about guarantees for a moment and focus on what is important, your purchasing power.

Finally, realize that there is no investment on earth that can guarantee your purchasing power under all circumstances and no product can ever be developed to guarantee purchasing power. Inflation-protected bonds do a decent job if you can accept an extremely lower rate of return, but overall there is nothing that can guarantee your income will grow with inflation. We expect that many assets will hold their purchasing power and those should be incldued in your portfolios, but always remember that even though a guarantee sounds great and makes you feel Warm and Fuzzy, there is really no such thing as a guarantee.