How to relax despite the stock market's ups and downs

David Prosser says guaranteed equity bonds may not be ideal protection in a falling market

Investment generally requires a trade-off between risk and return, so guaranteed products seem enormously attractive. Not only do they offer exposure to the stock market - historically, over the long term, shares have usually been the best-performing asset class - but they also guarantee investors their starting capital is safe.

Investment generally requires a trade-off between risk and return, so guaranteed products seem enormously attractive. Not only do they offer exposure to the stock market - historically, over the long term, shares have usually been the best-performing asset class - but they also guarantee investors their starting capital is safe.

There have already been almost 200 guaranteed equity bond (GEB) launches this year, as providers cash in on nervousness about the continuing sideways movement of share prices. Most bonds offer links to the UK stock market, but it is also possible to buy exposure to most developed markets around the world.

Nationwide Building Society has just launched its latest GEB, a typical example. Like others, it guarantees to repay your capital at the end of the term, in this case five years. Savers also get 80 per cent of growth in the FTSE 100 Index of shares in leading companies over the period.

Nationwide's Clive Parkinson says: "For people who wish to invest in the stock market but are worried about the risks, guaranteed equity bonds are the investment solution."

However, investment advisers are not convinced. There are a number of drawbacks to GEBs, they point out. The first is that the bonds can be more complicated than they first appear. Dan Kemp, an adviser at stockbroker Christows, says: "I'm concerned people don't fully understand what they're buying."

To provide capital security, bond providers have to invest your money in the derivatives market. This may produce a guaranteed return over a set term, but if you need early access to the cash, you are likely to be heavily penalised.

Also, if the stock market does fall over the next five years, you'll get your cash back, but you will still have suffered a loss in real terms. In contrast, if you simply deposit the cash in a building society savings account, you should at least keep pace with inflation.

Dividend income is also crucial. If you buy a share, you get two types of return - capital gains when the price rises, plus income in the form of dividends each year. GEBs miss out on dividends, because they don't invest in real shares, just the derivatives that are related to them. Currently, dividend income represents about half the annual return on equities, says Kemp. So bond investors are automatically missing out on a large chunk of potential gains.

Ben Yearsley, an investment specialist at independent financial adviser Hargreaves Lansdown, says: "These products prey on people's fears following a period of volatility and falling markets." He also warns they give investors exposure to the stock market in the wrong way.

GEBs are linked to market indices - the FTSE 100 in the UK, say, or the S&P 500 in the US. Yearsley points out that most experts believe investors will make the best gains from choosing individual stocks, rather than buying the market as a whole.

It is possible to buy open-ended investment products that do not tie you in for an extended term. Close Fund Management, for example, offers the escalator range, where a new base price is set every three months, below which the fund cannot fall. Gartmore and Family Assurance offer similar products.

However, Yearsley is not impressed. "The funds are even worse in some ways," he says. "They haven't even managed to outperform cash."

Rob Page, of New Star Asset Management, says that over most five-year periods, equities tend to outperform other assets.

"If you're going to invest over a sensible period of time," he says, "a guaranteed product means you'll be sacrificing potential upside to pay for the protection, and it is hard to argue that sacrifice is good value."

Page believes most investors would be better off with a basic spread of funds. "If you diversify through shares, bonds and property and invest over five to 10 years, you stand a very good chance of doing well," he says.

Shares that hold up in a downturn

* "Defensive shares are those which perform better when the stock market is struggling," explains Richard Hunter, head of UK investment at stockbroker Hargreaves Lansdown. "You're generally considering companies whose products consumers have to buy in all economic circumstances - because they always need to eat, drink or keep warm, for instance."

* Supermarkets are good examples, because they sell necessities rather than luxuries. "Sainsbury's is currently a more defensive stock than Tesco, because 20 per cent of Tesco's revenues come from non-food items," Hunter says.

* Alternatively, oil and gas utilities, which supply fuel for heating and power, can be a good defensive bet. Hargreaves Lansdown currently rates United Utilities, not least because it offers a dividend yield of about 7 per cent, which is more than twice the market average.

* Banks can be defensive holdings, because the largest companies have huge cash reserves. Lloyds TSB is performing well and pays decent dividends. It could even become a takeover target.

* Don't forget cigarette companies. Economists often describe demand for a product as elastic, if it rises and falls due to external influences such as an economic downturn. As smokers find it hard to give up, even when money is tight, cigarettes are a good inelastic product.