Don't be fooled by promises of guaranteed returns. It is critical to look for risks in an investment rather than seek assurances that are easy to give.
Investors love assurances. An assured return conjures up the image of a solid investment that will deliver on its promise. It seems like the best choice one can make with one's money. The truth is that delivering an assured return is the toughest act for an financial product. If investors think that assured return means a risk-free and safe investment, they should think again. The quality of the promise matters so much more than the promise itself.
Why is it tough to assure returns? The performance of an investment is primarily driven by the assets in which the investor's money is put to work. All assets are subject to risk. It is not possible to buy assets that will only appreciate in value. The degree of risk may vary, but no one can tell how an asset will perform in the future. Whether it is land, gold, houses, stocks or art, all assets are subject to the risk of price fluctuation. Prices are influenced by cyclical factors such as the state of the economy (the US housing prices crashed in 2008 triggering an economic recession), and structural factors that impact the specific asset. Some assets, such as property or equity, may face short-term risks that even out in the long-term, but they are risky anyway. All investment products are based on an underlying asset port-folio, which is risky by definition. Asking where, not how, the money will be invested is critical to understanding any assurance of return.
So, how do banks manage to assure returns on deposits? The answer lies in the balance sheet structure. A bank borrows from its depositors. Its assets are the loans it gives out to various borrowers using these deposits. The borrowers agree to pay a fixed rate of interest and return the principal, but their ability to keep the promise is again linked to their assets and performance. A person who has taken a home loan is likely to default, despite committing to a fixed rate of interest, if he loses his job or if his house drops in value significantly. Therefore, the bank's portfolio is also subject to risk. The bank does two things to keep its promise to depositors. First, it ensures that the loan portfolio is not completely risky and holds some safe investments in government bonds as well. Second, it does not fund all the loans with deposits, but ensures that a part of it is funded through equity investors who do not seek assurance. If the risk of the asset portfolio is borne adequately by equity capital, the bank is unlikely to default on its deposits. This is why capital adequacy is a regulatory requirement for banks that seek deposits from the public. This is also the reason that a bank with a poor quality loan portfolio or inadequate capital can default on it deposits despite assurance.
How does a company pay an assured return on its bonds? It does so by further extending the balance sheet structure used by a bank. Unlike a bank that holds loans, a company holds assets that are expected to generate future income. The risk associated with these assets can vary depending on the nature of the business. Therefore, a company has to be funded by its promoters even before it seeks any lenders. The lenders will, of course, want the company to have adequate equity capital already invested in it. They will ask an external credit rating agency to test the quality of assets that they are funding. As we know, these agencies can downgrade and change the rating unfavourably if a company is more likely to default.
How safe are government securities? The central government assures returns on its bonds and saving schemes because of its unique powers that provide it with three options to return the money it borrows. It can unilaterally increase the taxes, borrow internationally, or print money. We can, therefore, assume that the government will pay its liabilities. We know from the experiences in Europe that a government which borrows recklessly can also find itself in trouble, causing serious economic consequences for its lenders and citizens. Hence, the ability to assure returns comes either from the strength of the balance sheet in the case of a bank or company, and from special powers vested with a government. It is critical to learn how to look for risks in an investment, rather than seek assurances that are easy to give but tough to deliver.