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the magic money cupboard

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One of my friends is an actuary with an insurance company. His favourite concept is that of the magic money cupboard. He reckons that when it really gets down to it, a surprisingly large number of people (who should know better) believe that when you take out an investment policy, the insurance company puts it into a magic money cupboard, and after a few years, it comes out much bigger.

As my friend quite rightly points out, there is no magic money cupboard. If you save or invest money with any company, they can only put the money in the same places that everyone else does - broadly speaking into bonds, shares, cash, property or commodities.

When you take out a pension, or an investment policy, or anything like that, you are really investing in bonds, shares and cash (and occasionally property or commodities). The value of bonds and shares can and will go up and down, and cash is at risk from inflation. If the whole stock market is doing badly, then it doesn’t matter who your investment is with, if there’s any component invested in shares that bit will be doing badly too.

People that look after the money you invest are clever, have passed lots of exams, and are genuinely trying to get the best return for your money. However, they don’t work miracles, and they aren’t likely to do much better than average because they have to work from the same information that everyone else does.

There’s no such thing as a risk-free investment, and nothing is immune from the major ups and downs of the markets. Understanding and accepting an appropriate level of risk are much better for you than mistakenly believing that the insurance policy you’ve taken out will make money come rain or shine because then, you’re taking on risk that you don’t even know about.

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9 comments for “the magic money cupboard”

  1. You are correct, of course, however there are some ways in which professional investors could (theoretically) make more money than individual investors:

    1. Lower costs - more money managed means that the company incurs less overhead per dollar invested,

    2. More Assets - individual investors have limited access (or some times no access) to certain asset classes - e.g. hedge funds, and theoretically if those assets do better than your typical stocks and bonds, and insurance customer would tend to do better.

    3. Better Information - if you buy the theory that professional investors can get better information about the market (e.g. by spending more resources on research) than it is possible that they will be able to generate better returns.

    I actually don’t believe any of the above three. Fact remains that insurance is typically a worse form of savings than investing your own money in index funds… you have to remember that the insurance company needs to make a profit as well, and that profit comes at the expense of your return…

    Posted by Shadox | February 21, 2009, 7:57 am
  2. They may not have a magic money cupboard, but unfortunately the professionals charge like they *do* have some special insights or access…

    Posted by Monevator | February 21, 2009, 9:31 am
  3. It is amazing that even in this financial climate people are unrealistic about whether will make money. Banks are paying really low interest rates on savings and ISAs we are hearing in the news all the time about financial uncertainty and people still believe they can make money fast and large amounts of it, its amazing.

    Posted by Charlotte | February 23, 2009, 1:46 pm
  4. Well technically there are risk free investments. In Canada and in the States too (I’m not sure on the numbers in the states though), the CDIC insures up to 100 000$ in your account.

    Then you have GIC’s (Guaranteed Investment Certificate) and they are also protected and offer rates from 1.8% to 5% at the major banks even too this day.

    Posted by brick wall fireplace | February 24, 2009, 10:16 pm
  5. Brick Wall Fireplace: even these investments are risky. You’re taking the risk that the inflation rate will outpace the guaranteed rate of your investment. This has happened in every modern country at some point or another (especially in the ’70s). Even inflation-protected investments with the government have risks since there’s always the chance that the government will default. In the United States, Treasuries are seen as a “risk-free” investment, but we can’t know for certain that the U.S. government will never default even if it seems extremely unlikely. (And we’ll probably have more important things to worry about than our investments if it does happen.)

    Posted by Andrew Stevens | February 27, 2009, 4:13 am
  6. Sorry about the name it’s for keyword purposes, I can be refered to as David :).

    But if your government defaults, you’ll have bigger worries then what to do with your probably useless money so the possibility that your government would default shouldn’t be considered and should be placed along the lines of people worrying that a meteroite will fly through their window and strike them in the head.
    In all practical purposes they are safe and insured deposits.

    So I mean we can consider it, and now I see that you did mention this, but it’s really it shouldn’t be worth mentioning. Would I not go to work the next day fearing that I will be sucked through a microscoping black hole? Although it is a possibility, the chance of it happening is so slim that for arguments sake it shouldn’t be considered.

    On the inflation rate issue, if you keep your money underneath the bed you’ll be hurt more by inflation then if you had placed your money in a investment portfolio (assuming you make positive interest).

    Oh and if the US defaults, you can all use the good ol’ loonie :).

    Posted by brick wall fireplace | February 27, 2009, 6:36 am
  7. David, all of what you say is true. I’m just pointing out that all investments have risks. If you put your money in a savings account which makes 5%, but inflation runs 8%, you’ve lost money. If the stock market makes 20% in the same period, you’ve lost even more money compared to what you could have gained. There is, of course, far more downside risk in the stock market than in a savings account, but even the savings account isn’t riskless. (Yes, it’s better than under the mattress, but that’s part of the point. Under the mattress is just about guaranteed to lose money, as inflation eats it up.)

    I do believe that the closest thing to a riskless investment is inflation-protected government securities. But even that carries an upside risk, in that there’s an excellent chance that you could do better investing elsewhere. We shouldn’t be so focused on the downside that we forget about the upside.

    Posted by Andrew Stevens | February 28, 2009, 6:56 am
  8. It can be astounding that even in this financial climate people are unrealistic about no matter whether will make money.

    Posted by generators | October 26, 2010, 2:58 pm

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