By DAVID MOON, Moon Capital
September 28, 2003
I never saw any of the forty-seven different Friday 13th movies, but my
understanding is that an unfriendly creature named Jason keeps returning to
attack unsuspecting teenagers.
If you've considered buying the newest thing - a bank CD with returns
'linked' to the stock market - you're flirting with Jason. No, these
FDIC-insured CDs won't chop you into little pieces. But like Jason, they
do keep coming back to wreak havoc on their victims.
Each generation of equity-linked CD looks a little different, but they won't
go away and stay away. And the result is the same: investors think they
are buying something that guarantees the possibility of stock market returns
with no downside risk. Au contraire.
The pitch has become more sophisticated. The new products promise that
your minimum return will equal 100 percent of the S&P 500 return, with a
couple of caveats. There are always a couple of caveats.
The big exception is that your quarterly return is limited to, at most, five
percent, regardless of the return of the S&P 500. But there is no
similar limit when the S&P 500 declines ' you get all of the losses.
If the S&P 500 increases twelve percent one quarter, followed by a seven
percent loss the following quarter, an investor might expect the value of his CD
to increase by about five percent. (The 12 percent increase, less the 7
percent decline.) But because the first quarter's return is capped at five
percent, the seven percent loss in the second quarter more than offsets the
limited gain in the previous quarter. You get all of the downside, with
only limited upside.
This isn't a good bet. The S&P 500 return was positive in only four
of the last nine quarters. In each of those cases, the positive return
exceeded five percent. The return of this type of CD would have been
capped. But the downside quarters were significant. In three of the
quarters, the loss exceeded more than thirteen percent. Does that sound
like a great deal? You get credit for all of the downside and only some of
the upside? In the last five years, there would have only been two
quarters in which the return of such a CD would not have been limited by the
On the positive side, these CDs are FDIC insured. And they do guarantee
a minimum of a three percent TOTAL (not annual) return over a four or five year
period. No one is going to lose their money. But they aren't likely
to get what they expect, either.
The investment climate in which this type of product is likely to do best in
one where the returns of the S&P 500 aren't very volatile (less than five
percent a quarter changes) and are generally positive. But if you expect
that kind of stock market, you would buy stocks, not CDs. And if you
wanted to hedge your stock investment, you would put some of your money in
something paying a reasonable guaranteed interest rate, not a total of three
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).