Originally published: January, 2005 (Phillips, Hager & North Investment Funds Quarterly Report)

Context of the article: In 2005, Principal Protected Notes (PPN's) were again big sellers during RRSP season and were garnering a lot of attention amongst individual investors. The research that I had done, with the help of analysts at PH&N, was telling me that these were poor products for the clients. Using PPN's as a construct, the article reviews the concept of taking risk to generate higher long-term investment returns. It takes the view that most investors shouldn't dilute their long-term returns for the sake of short-term certainty.

Are investors going too far for the sake of certainty? Are they buying more insurance than they really need?

In the late 1990s, no one worried about risk or certainty. It was the "greed" part of the investing cycle and everyone was in hot pursuit of higher returns. The question most often asked was "How high?" not "What's the downside?"

My sense of things today is that the investing public has swung too far the other way. The focus is so keenly aimed at the downside risk that they are needlessly accepting lower long-term returns.

I say that because the investment products that have been big sellers in recent years have been income funds, conservative or income-oriented equity funds, and a variety of products that guarantee the principal (generally called Principal Protected Notes or PPN's). With a PPN, which can come in all shapes and sizes, the investor is assured of at least getting his or her original investment back when the security matures. The trade-off, however, is that the potential return is meaningfully reduced. Statistics I saw recently showed that sales of the most popular of these products - market-linked GICs and equity-linked notes - totalled $18 billion in each of 2002 and 2003, and I suspect the number was higher in 2004.

It's easy to see why this is happening. We're surrounded by things that make people edgy - terrorism, the weak dollar and twin deficits in the U.S., and high energy prices. More specific to investing, the new millennium has been a bumpy road for equities. On balance, returns have been positive, but there have been lots of ups and downs along the way. And because the bear market caught people by surprise, many are focused on preventing the down, rather than capturing the up. As a result, there is a tendency to take precautions and prepare for what has already happened - what we call investing by the rear view mirror.

Before we answer the question, "Are investors buying too much insurance?", let's review a few basics.

First, investing involves buying long-term assets (bonds, stocks, real estate, art, and perhaps antiques) that will grow faster than inflation over time. These assets are suitable for investing because they are by nature risky, and risk is the raw material required to generate attractive returns.

Second, with risk comes short-term uncertainty and volatility. The value of long-term assets will go up and down, depending on the view of the market (the buyers and sellers) at any one time.

Third, if investors want less uncertainty and volatility, then they have to use less of that key ingredient, risk. And that will cost them money in the long term. The cost comes in two forms: increased fees and foregone returns. In the current environment, the cost of certainty is particularly high. For principal protection, the banks are receiving an excellent premium despite the fact that they're taking on very little risk. This premium is not always obvious because it's embedded in the cost of the product.

These basics lead me to the point of this article. If you don't need short-term certainty, then don't buy it. It's too darn expensive.

Having got that off my chest, let me take a step back and acknowledge that there are investors who should forego higher long-term returns for the sake of certainty. There are lots of circumstances where it's appropriate. It makes sense if you're saving for a large expenditure in the next year or two, as opposed to investing for retirement. It makes sense for a charitable organization that has near-term financial obligations. It makes sense for older individuals who are drawing on their capital to fund their retirement. In each of these cases, the need for money is immediate, or not far off, and the balance between the upside and downside is not symmetrical. In other words, the consequence of negative returns is far worse than the benefit of higher positive returns. Any decision to introduce risk into the portfolio has to be made after addressing the question: "What can I afford to lose before I'm severely impacted?" Clearly, for investors in these circumstances, it's worth giving up some long-term return for a degree of certainty.

But there are a whole bunch of investors that don't fit that mold. Their need for money from their portfolio is many years away and, importantly, their upside/downside balance is symmetrical,  i.e., the impact of short-term negative returns does not outweigh the benefit of higher long-term returns. I'm referring to younger people who have 15-30 years of saving ahead of them before they retire, or older investors who aren't putting a dint in their portfolio, either because they're living off pension income, or because their assets are so substantial. Effectively, these "veteran" investors are managing their portfolio on behalf of the children or charities that will inherit the money when they pass away.

For this category of investor, the evidence is overwhelmingly against buying insurance (certainty) in their portfolio. Since the founding of PH&N in 1964, there have been very few five-year periods when Canadian equities had a negative return (2.1% of the time, to be exact)[1]. There has never been a seven-year period when the return has been negative. And yet, as Art Phillips or Bob Hager will tell you, there were some pretty tough periods for equity investors over those 40 years. Interestingly, many of the Principal Protected Notes being sold these days have five- or seven-year terms. Buying one of these products is like paying for flood insurance in the desert.

For investors who are still building up their portfolios, volatility is a friend, not a foe. As Warren Buffett likes to say, these investors should be delighted when the market is down because their dollar goes further. If I recall correctly, he uses the analogy of buying hamburgers: the lower the price, the more hamburgers you can buy.

This article is aimed at investors who are buying insurance they don't need. But even investors who do need some degree of certainty should be aware that there are lower-cost forms of insurance. Diversification is the cheapest insurance you can buy. Indeed, many investment icons refer to it as the only "free lunch". By owning a diversified portfolio of long-term assets, an investor can significantly reduce the possibility of negative returns. As a part of that portfolio, there are a number of securities that have good defensive characteristics. A mutual fund that owns short-term corporate bonds fits that bill, as does one that owns dividend-paying stocks.

Most people hate to pay taxes. They'll avoid it at all costs. I just wish that more people would be as fanatical about not paying for investment insurance. At least taxes go towards government services all of us can use. Unnecessary insurance premiums end up in the pockets of much less needy citizens.

[1] As measured by the S&P/TSX Composite Index and, prior to its inception, the TSE 300 Index.

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