“THE FREE LUNCH SYNDROME” or
7% Guaranteed Growth with No Downside
אויך גוט זיין אמת
Aoykh gut tzu zeyn ams
Das ist zu schoen, um wahr zu sein
Too good to be True
I. Is there a FREE LUNCH in Investing, ~Contact.FirstName~?
I think there is something inherent in human psyche that makes us want to believe in free lunches, risk-less investments and the pontifications of so-called gurus.
It is this basic human desire to want to believe in free lunches that has led to the expression: “Too Good to be True” or there is “No Free Lunch”.
I grew up in a household of immigrants often hearing four languages being spoken during the same dinner conversation. I always found it fascinating when the exact same expression would come up in different languages. “No Free Lunch” and “Too Good to be True” are two such expressions that I often heard as a child—in four languages! So, it really did make an impression on me.
This also speaks to the universal belief that we must be careful of our human tendency to look for easy answers, simple solutions, and “free lunches”—they really are “too good to be true”.
II. How do you Spot “FREE LUNCH” Investing Marketing?
I was reminded of this truism last week when a client told me about a ZOOM workshop he attended where the speaker promised those in attendance the ability to make a guaranteed 7% rate of return with a second guarantee of no loss of principal. WOW! 7% upside with NO downside potential.
Not bad, I thought. Except, it really is Aoykh gut tzu zeyn ams; Too Good to be True”.
III. Definition of Free Lunch Investing and why it doesn’t Exisit!
The phenomenon of FREE LUNCH Investing is so common that there is even an entry “FREE LUNCH INVESTING” in Investopedia.com:
Why does free lunch in investing not exist?
- A free lunch in investing cannot exist because of the constant trade-off investors make between risk and reward. The greater the inherent risk in an investment, the greater the reward. This is a fundamental truism. Conversely, securities with less risk generally have commensurately lower returns.
Free Lunch – investopedia.com
IV. Why was Too Good to Be True?
My client told me that the speaker at the ZOOM Workshop promised 7% annual guarantee rate of return and 100% guarantee of principal. WOW! That sounds great, doesn’t it? I had heard this “free lunch” investment pitch before, so I knew what the real story was.
Embedded deeply in the product brochure was the disclaimer that the 7% annual guarantee was ONLY for determining future income payments. What does that mean?
It means the 7% guarantee is really an illusion. Think of it this way: The insurance company maintains a separate ledger for the actual investments and a ledger for the “income rider”. If the investments fail, then they will base your income payments off of the account that supposedly grew at 7% per year.
How does this work? The insurance company’s “income ledger” showing the 7% annual growth as a Guaranteed Amount.
However, you are not allowed to access this money, transfer it, or even directly draw the funds out. The Insurance company will use this fictional amount as a way of determining your annual income payment which will be a percentage of the overall amount.
Example: Your income rider amount that has been growing at the guaranteed 7% annually is now worth $100,000. Are you allowed to access the $100,000; transfer it to another investment company, ask for a $100,000 withdrawal? NO!
The insurance company will use this amount to determine how much they will pay you each year based on your age and life expectancy. So, you may be able to withdrawal 4% of the base amount of the $100,000 or $4,000 per year. So, in reality, you will receive 4% of the amount that grew at 7% spread over your life. So, the 7% guarantee is illusory at best and mis-leading. THERE IS NO FREE LUNCH.
If there really was an investment that would pay the investor a guaranteed 7% with NO risk to the underlying investment, wouldn’t everyone would be jumping on this bandwagon?
V. What is an Investor To do?
I know it is boring, but the best way to grow wealth is to create a plan that reflects the amount of risk you can tolerate based on your risk tolerance, age, and long-term goals. Then, the investor must be disciplined and work the plan over time.
There is a direct relationship between the amount of risk in an investment and the potential reward. Risk and Reward are like two sides of one hand; you are not able to de-couple the from of your hand form the back of your hand.
In the same way, you are not able to separate the amount of risk in an investment from the anticipated return. If someone tries to tell you otherwise, just know “Das ist zu schoen, um whar zu sein”—THAT IS TOO GOOD TO BE TRUE.