What Is a Buffered Security?
By Ric Edelman
Something to do with old pigs and new lipstick
The financial services industry loves to churn out new products with promising names. But do these products offer genuine improvements over currently available investments, or are they simply marketing gimmicks to attract assets from unknowing consumers?
This brings to mind the case of the Buffered Security.
I first heard about this offering from a caller on my radio show. She said her bank was offering an investment that guaranteed a limit on losses while offering profits that are twice as much as the stock market. It sounded intriguing (which is a polite way of saying too good to be true), so I asked her to send me a prospectus so we could investigate it further. She did, and I wasn’t happy with what we found.
Here’s what the product promises: You invest your money, and if the stock market rises, your account will be credited with twice the amount of that gain, to a maximum of 10%. If the stock market falls 10% or less, you don’t lose anything. But if the stock market falls by more than 10%, you take all losses beyond 10%. The chart below illustrates the results of a variety of market gains and losses.
The chart makes this product look like a good idea, but when you examine the product more closely, you can see the flaws. First, the product determines the market’s results on a calendar-year basis, and although the stock market has produced an average annual return of 10.5% per year from 1871 to 2009, according to Robert Shiller data, it often has produced gains and losses that exceeded the product’s 10% threshold. In fact, over the past 140 years, this product would have provided investors with an average return of only about 3% per year.
Why? Because the stock market sometimes loses more than 10% in a year. In 2008, for example, the S&P 500 fell 38%, meaning an investor in this product would have lost 28%. And in 2009, when the stock market gained 27%, this product returned only 10%. In short, investors have limited upside potential with unlimited downside exposure. No wonder investors in this product are likely to find themselves taking some large losses while earning low returns.
The buyers of this product might also be taking risks they don’t realize. Similar products, such as structured CDs, have been available for years. But unlike a bank CD, which is FDIC insured, a buffered security is a note that happens to be issued by a bank. Should that bank fail, your money could be gone too.
Buffered securities are also illiquid. Once you invest, you can’t get your money back until the note matures. In the case of the prospectus the caller sent me, her bank’s product would take 18 months to mature.
Other products take as long as 10 years. Sales pitches are meant to make products sound appealing. Make sure you do a full analysis before investing or, like this caller, ask an independent financial advisor to do an analysis for you.