FOOL'S EYE VIEW
Financial Products To Avoid

By James Carlisle
November 6, 2002

Investment is all about 'risk and reward' and maximising your expectation of the latter against your requirements for the former. Unfortunately some financial products spoil the balance simply by their design. Either they increase your risk with no expectation of more reward, or they reduce your expected rewards while doing nothing to moderate your risk. This makes them fundamentally bad products. Here's my take on the five worst.

Funds of Funds

Normal managed funds are lucky to escape this list in first place! With them, you pay more (thereby reducing your expected return) to actually give yourself a chance of deviating from the market average (thereby increasing your risk). Doesn't sound too great, but some people like them because, despite a wealth of contrary evidence they think they can pick the 'right' funds.

Funds of funds are a special type of fund where you pay a further fund manager to select the 'right' managed funds for you. Needless to say, they don't do anything other than an average job of it. More than that, though, by picking a pile of managed funds, you radically reduce your chances of deviating much from the market average. That might be a good thing, except that it removes the only plausible argument in favour of managed funds -- that you want to deviate from the market average.

If you want the average performance of the stock market, then do the sensible thing and buy an index tracker. You'll save yourself a per cent or so in charges and thereby add a per cent or so to your expected annual return.

Endowments

What can I say about endowments that hasn't already been said!? They've had a bad press recently, so much so that they're rapidly disappearing, and it's about time too. The bad press is actually nothing new. The difference is that people, including the FSA, have finally taken notice of it. Here's an quote from the Daily Telegraph on 31 August 1991, back at the height of the endowment boom (we liked it so much we pinched it for the Motley Fool UK Investment Guide):

It cannot be said too often that the advantages to the householder of an endowment mortgage are as nothing compared to the gain to the policy salesperson, that life assurance has nothing to do with house purchase, and that savings-related life assurance is a waste of money.

The number one problem with endowments is that they have such a complex structure that hardly anyone understands how they work, including most of the people that sell them. This makes it simple to hide indecent commissions and other charges. All of that comes out of your returns. They're also very inflexible so that once they've managed to sell you one, it'll cost you an arm and a leg to get out. If you want an investment, then look for an investment, not for life assurance!

Bond funds

Corporate bond funds maybe aren't so bad, so long as you understand exactly what you're getting into. The trouble is that, all too often, people don't. Their advertisements tend to scream out a huge annual yield -- "Supernova Investment's 7% Bond Fund" -- and, unfortunately, a lot of consumers don't get as far as the small print that says that they might lose you money.

The truth is that the advertised yield on these funds counts for very little. You can tell that from the fact that it's so much more than current interest rates. If they're offering you a 7% return, you know that it involves some risk. If you're capital went down by a few per cent, which is more than possible, then what's the good of that 7% headline yield? In addition, annual charges of around 1.25% make a big dent in your returns.

If you want a safe fixed-interest investment, then you're better to stick with gilts. If you're looking for more return for more risk, then find a cheap way of investing in the stock market.

Anything that's advertised on daytime TV

Financial companies need to tell us about what they have to offer and that's perfectly reasonable -- otherwise there wouldn't be any financial products! But always remember that you, as the consumer, will ultimately pay for the advertising through charges on the product. Financial services companies are not charities!

Think about how much all the advertising might be costing relative to the amount of money a particular company and product deals with. Things like bank accounts and mortgages deal with so much money that a few TV adverts won't hurt (from the big companies). But when you see a 'B list' celebrity on daytime TV recommending First Forgotten Finance's Fifty-Year Flexibond, you know you've moved off the straight and narrow.

Anything that you don't understand

If you're not in a position to make an evaluation of the risks and potential rewards offered by a particular product, then you shouldn't have anything to do with it. Unfortunately nothing in finance is completely straightforward, so you'll need to do some learning to get yourself up to speed with the basics (a good place to start is the Fool School). But there are some things that are broadly understandable and others where you'd maybe need a first-class degree in mathematics to work out what's going on. You want to stick to the former and have nothing to do with the latter, unless you've got that first-class degree! So steer clear of things like 'Guaranteed Stock Market Bonds' and 'Split Capital Investment Trusts'.

So, if there's a simple rule to follow, then it's keep it cheap and keep it simple! Simple products would include the Fool's much-loved index tracker (perhaps wrapped up in an Individual Savings Account or a Stakeholder Pension) for long-term savings. For short-term savings, there are bank accounts, gilts and National Savings. Any Fool can happily go through their financial lives with a blend of these products plus a little insurance.