Money Angles: A Primer on Market Pitfalls

Citibank has been taking full-page ads for what it calls its Stock Index Insured Account. "With this unique account," runs the ad, "your IRA or Keogh deposit actually earns two times the average percentage increase in the Standard & Poor's 500 Index over a five year term. Yet it's 100% safe."

Double the S&P with no risk?

"I've only been in this business 25 years," confessed the president of a large brokerage firm, "but I can't for the life of me figure out how Citi can be offering people double the S&P."

Of course, there's a catch. No way could Citibank actually offer you double the stock-market return with no risk, though its ad and brochure make every attempt to convey that impression. But it's entirely legal, fiendishly clever (in a friendly, relatively harmless sort of way) and just one of the many things to be wary of as we desperately reach for alternatives to the 2.5% they're offering down at the local money-market fund.

Close reading of the Citibank ad tells the tale. But if my friend the Wall Street mogul didn't get it, how many widows and orphans will?

First, it turns out, you get none of the dividends the S&P 500 stocks pay over those five years; Citi keeps them. From 1961 to 1992, the S&P 500 has grown at 10.2% a year -- but only 6% a year if you exclude dividends. Second, Citi doesn't double the five-year gain in the S&P, if there is one. It looks at the average of the S&P over those five years, compares that average with the S&P when you started, and doubles that gain. Well, if a tree grows to be 5 ft. tall in five years, it's grown 5 ft. -- but its average height over those five years was only 2 1/2 ft. So doubling it ain't such great shakes after all.

But it's worse than that, because while trees only grow, the stock market sometimes shrinks. (Many of you are too young to believe this, but it's true.) What makes this deal work so well for Citi is that the downs reduce the average of the ups. Say the S&P, which is today near its all-time high, drops 25% over the next year, then just bounces around aimlessly until the fifth year, when it explodes, gaining back that 25% loss plus an additional, mouth- watering 50%. (These things happen too.) Had someone just bought the S&P 500 and held it for five years -- someone like Citibank -- he'd have got that mouth-watering 50% appreciation plus five years' dividends. Not bad. But had someone rolled his IRA over into Citi's Stock Index Insured Account, he would have got . . . zero. (In calculating the average, the first 48 bad months would have more than canceled out the final 12 great months.) His principal would be safe, but it wouldn't have earned a dime.

Naturally, this is not the example Citibank uses in its ad.

The most obvious risk to Citi is that, five years from now, the S&P will be lower than it is today, and Citi will have to make up the difference. But because the market's natural bias is up, what with growth and inflation, it rarely falls over any five-year stretch.

The less obvious risk is that the S&P might zoom 75% right off the bat, say, and then just sit there for five years. That would be an "average" 75% gain, which Citi would have to double. Wow. But, my friends, the chances of the market zooming 75% anytime soon are . . . Well, forget about it. In any event, Citi can hedge against these risks.