The Case Against Principal Protected Notes

The Case Against Principal Protected Notes

With the stock market at its all time high, brokers at Merrill Lynch, Morgan Stanley and JP Morgan Asset Management are touting an instrument called “principal protected notes.”  These notes come in a variety of different forms, but the structure is usually pretty similar.  You buy a note with a 100 par value tied to an S&P price that is set on the day of pricing.   If the S&P were to be trading at 2500, that would be your S&P price.   At the point of maturity, usually 5 years, you receive a percentage of the increase in the value of the S&P (usually between 50% and 70%) with your total appreciation usually capped around 30%).

These things are actually selling like hot cakes, especially now that the market is at its all-time high.   Brokers will tell you that you are not putting your principal at risk (which is correct so long as the underlying offeror does not default).  The notes, therefore, are very attractive to people who are risk averse and are upset that they have missed a huge run in the stock market.

Even if fear of missing out (FOMO) is your issue, this is not the right instrument for you.

Proper investing and proper financial planning involves having a portfolio of equity, debt securities, cash and other instruments (such as real estate, gold or other commodities).  

If you purchase one of these instruments, you are buying something other than equity.  Rather, you are buying an instrument that does not let you fully participate of the market, instead only giving you fractional participation, and that does not provide you with the dividend income on the S&P 500, currently about 2.2% annually.  That 2.2% dividend yield, when compounded, is roughly 11.5% over a five-year period.  Foregoing that yield is your "cost" of hedging the offeror's downside exposure in the instrument, but it is also cash out of your pocket if you have a long-term intention to stay invested in the market.

Likewise, the idea that your purchase of principal protected notes is just as good as cash if the market is lower in 5 years is also erroneous.  Your cash – if left in cash - will compound over the 5-year period no matter where interest rates go.  But, with interest rates poised to rise in 2017, 2018 and beyond, your cash could potentially compound at quite a high rate.  Even if you were to lock into a 5-year CD today (the best rates are currently just over the 2.2% S&P dividend yield), you are certain to see a compounded return over the life of the CD of just over 11.5%.

You need cash and you need equities.  A principal protected note is neither.

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Trump Does Not Mark the End of Civilization As We Know It

Trump Does Not Mark the End of Civilization As We Know It

We have, indeed, elected a not very intelligent, unstable man as the next president of the United States.  He did, clearly, appeal to many of the least attractive aspects of human concerns and beliefs.  But this is nothing new: think even relatively recently of Nixon, George W. Bush, even Obama.  We have not done especially well, throughout history, of picking wise, even-handed, bold and prescient leaders.  Democracy may not be the best means to identify and to bring to power the best among us.

We’ve survived, and we will again – even the reign of Trumputin.  The people who voted for him, in spite of, or because of, his cabinet appointments, his continued embracing of Russia, his off the wall pronouncements, continue without interruption to champion his win and support his “positions.”   But the enthusiasm of a very different group, where one sees near ecstasy, is even more telling of how missing the mark are so many critics today.  I am talking about the market makers and large investors who are celebrating the end of massive regulations and the freedoms they see in this new administration.  One could explain the initial upswing in the market as just a knee jerk reaction to the end of the Obama regime and all the politically correct and anti-business policies of the past eight years.  But, that it continues unabated, two months after the elections, portends something much more – something major and important.  Because, if the market and the economy continue thrive anew after years of treading water and gasping for air – imbued with new energy - then there is and will continue to be something to celebrate. And, just maybe, we will also see an interest rate environment which isn't held artificially low by the Federal Reserve and a banking system which is no longer derailed by excessive regulation.

Two months, sixty days, is more than just a momentary burst of hope.  Let’s see it for what it well may be – a new and fresh moment for innovation and prosperity – and let’s move on with our lives in a country that may never get it absolutely right but that can embrace differences and silliness without revolution and disintegration.

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Trumputin

Trumputin

We should all be shocked by the unanimous findings of our intelligence agencies.  As the implications begin to sink in, the impact of an illegitimate president about to take office for at least four years are deep and far ranging.  And “at least four years” is optimistic.  Traditions will be violated and conditions will erode fast.  Hanging on may be the best we can hope for.

And, the double shock of comprehending that the one person who knew all and who could have taken bold and unprecedented action before the election to prevent this crisis – the then sitting two term president – did absolutely nothing.  Yes, nothing – his default position all these last eight years.

Relying on key members of Congress to take a stand now is not an option.  Every one of them, even those posturing loudly today, are too interested in protecting their own cushy jobs.

So, it behooves those with any money – large or small in sum – to take prudent, very prudent action now.  The market has taken off since Trumputin was elected, but that has been just a relief rally – a relief that Hillary Clinton will not extend the Obama years.  But, it won’t be long before investors come fully to grips with the implications of an illegitimate president – especially a dangerous and unpredictable one.

Given our new reality, we all need to consider carefully the proportion of our investments we leave in the market.  But we also need to adopt the mindset of our ancestors who confronting political instability converted many of their assets into cash, diamonds and gold.  You will want to consider doing the same – buy gold and diamonds and put money away in multiple federally insured bank and CD accounts, up to the limit of insurance for each.  

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