Premium Bonds in depth - A bad investment?

Premium bonds explained

Premium Bonds: What are they? How do they work and should you get some? This article discusses the pros and cons of buying premium bonds.

What are Premium Bonds?

Picture from freedigitalphotos
UK Premium bonds are simply bonds that instead of paying interest enter the owner of the bonds into a monthly prize draw in which the owner has the potential of winning prizes valued between £25 to £1 million. You can invest anywhere between £100 to £50,000 into premium bonds. Obviously the more bonds you own, the higher your chances of winning a prize in the monthly draw.

Benefits of Premium Bonds

There are a few benefits of buying premium bonds. First of all the winnings of Premium Bonds are tax free. Secondly, the Bonds cannot go down in price so you can sell your bonds for whatever you originally paid for them. Obviously the real value of these bonds would have gone down due to the effects of inflation. The money is backed by the Treasury so the capital is 100% safe. There is the potential for large winnings (I use this word rather than returns deliberately).

Problems with Premium Bonds

The average annual returns of Premium Bonds are 1.5%. This appears quite a poor return when compared to average Cash ISA accounts that currently pay on average, a 3% return. Furthermore the 1.25% is not actually what you will get per year. For example if you hold £100 of premium bonds you are not going to get £1.25 a year because the minimum prize is £25, and you actually have to win to get the prize of which the chances are roughly 30000:1 per pound invested. As you can see, an individual is very unlikely to win in their first year with £100 of premium bonds. The odds suggest that a person with £100 is likely to win a prize every 20 years.

Premium Bonds - More chance of winning the lottery?

The fact that £100 will only win you £25 within 20 years if you have average luck makes it quite astonishing that Premium Bonds are some of the most popular bonds in the UK with one in every two people holding them. I was wondering if you had more chance of winning the lottery:
Premium Bonds: The odds of winning per £1 is 30000:1 with prizes ranging from £25 - £1million

Lottery: Odds of winning a prize in the lottery with £2 roughly 54:1 with prizes ranging from £25- £5million
Basing our evaluation purely on odds, I find it quite amazing that a £2 investment is more likely to win in the UK national lottery than to win in Premium Bonds. Of course I have missed out the fact that your investment in the lottery is a one off, whereas your investment into Premium Bonds is for life if you so wish it. Let's change the numbers slightly:

Premium Bonds: The odds of winning per £100 is 300:1 with prizes ranging from £25 - £1million. Essentially this allows you to play a lifetime amount of lotteries. Let us say you bought the Bonds when you were 20 and die at 80. That is 60 years of monthly plays at this lottery, essentially 720 plays. In that time you should win at least twice.
Lottery: Odds of winning a prize in the lottery with £2 roughly 54:1 with prizes ranging from £25- £5million. However, this time we allow you to play once every week for 50 weeks (totalling £100). Clearly from the odds are that you are likely to win only once in this time period.
As you can see whether you invest in Premium Bonds or the lottery, it is a gamble in both as to whether you win or not. The numbers suggest that in both you are likely to be throwing away your £100. The question is therefore: Would you rather throw it away over 60 years but win a prize once every 20 years or would you rather throw it away over two years but win twice in that time. Honestly if I had to choose based on numbers I would choose the second option. 

Premium Bonds - the qualifier

So the question is:
You've just been given £100, where do you put your money?
The interesting thing is that even though I know the  low odds of winning I own Premium Bonds and have played the lottery twice. Amazingly I held £100 of Premium Bonds for 3 years and won £25 twice! Not bad. Logic states that I've had above average luck and should sell my bonds now while £100 is still worth £100!

Unfortunately I am not as sensible as this and will probably leave my premium bonds forever. For some reason I enjoy the excitement of thinking that one day I might just win big. Even £500 would be an unbelievable win. You've got to be in it to win it, and sadly this slogan had talked me into making what is, on paper, a bad investment.

Readers, am I a fool? Why do we invest when the numbers are clearly against us? Have any of you bought Premium Bonds? Would you rather play the lottery 100 times over than buy £100 of Premium Bonds, or would you do neither?

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