Wednesday, 18 April 2007

Worst 10 Financial Products by Neil Faulkner of Motely Fool

By Neil Faulkner 17 April 2007

There are loads of terrible financial products out there.
But that's not the biggest problem. The problem is that most of these products are useful for a small number of people and so regulators are happy to let them continue. If a product helps just a small number of people, its existence is justified.
However, if a product is very profitable it'll often be sold aggressively, and not just to the handful of people who would benefit most. That's why I'm not saying that the products listed here are unsuitable for everyone, but I certainly think that they are not suitable for the majority of Fools.
Anyway, here they are: the ten worst products in no particular order:

1. 'Guaranteed' Equity Bonds
I could have chosen a few different types of bonds to criticise, but Guaranteed Equity Bonds (GEBs) make the most frequent annoying appearances in my email inbox.
The idea is that your investment is tied to the performance of the stock market. After a fixed period, usually five years, you get your money back plus any increase in the market. Sometimes they'll even offer, say, an extra 10% of the increase. If the stock market has fallen at the end of the period, you still get all your initial investment back. That's the guarantee.
On the surface this sounds great, but in reality it's pretty shabby. Firstly, with GEBs you get any capital gains from the market and sometimes even more, but you don't get the dividend income. Each year, many listed companies pay out a dividend, which can be reinvested. Compounded over five years this could quite easily mean a gain of 20% or more. With Guaranteed Equity Bonds, you get none of this.
Secondly, your money is locked in for the whole period, so you don't have the flexibility you get with other investments.
Thirdly, guaranteeing that you get your money back is not much of a protection. Over the five years your money will have been eroded significantly by inflation, meaning, in real terms, you will get less money back than you put in. If you need a real guarantee, you should put some or all of your money in a decent
savings account instead, which should keep you ahead of inflation and keep your money flexible.
Fourthly, negative five-year returns are very infrequent. 123 of the 131 rolling five-year periods from 1869 to 2004 have provided investors with a
positive result. So why not stick with a simple, tax-efficient shares ISA?
> Read our guide:
ISA And Investment Funds.

2. The payment protection racket
We've been banging on about payment protection insurance (PPI) for years so, if this is the first you've heard of it, where have you been?
PPI protects your loan, mortgage or credit-card repayments against sickness, injury or unemployment. It sounds good in theory, but these policies are so littered with exclusions as to make them worthless to many people. Plus, if you buy your insurance from your lender, it's vastly over-priced.
>
Fool Fights Rip-Off Insurance.

3. Poor store cards
Store cards are another unFoolish product, if used badly. It's all very well if you sign up to get the initial discount, but consider why retailers offer this to you? It's because they know that many shoppers will leave the balance on there for more than a month, so they can charge interest at incredibly high rates, often around 25%. If you get a store card for the introductory discount, pay it off straight away and never use it again.

4. Not-so-secure loans
Every time I've looked at a case to see whether someone should get a secured loan, I have always found a cheaper, better alternative. These loans are supposed to be good for people with high incomes, because it allows them to borrow more than £25,000, which you can't do with unsecured loans. However, a Fool has to ask himself if borrowing that money will really make him happier. Often the answer will be no.
That's why many people say that these loans are more suitable for poorer or more indebted people, as it can be seen as a way to consolidate debts. However, Fool research has found that, five times out of six, people taking out these loans go on to rack up more debt.
Keith Tondeur, national director of the money education charity Credit Action, said that for the people who contact them with serious debt problems, secured loans are suitable only 3% of the time. We're not talking about 3% of the population here, we're talking about just 3% of people on the edge of insolvency. That's no more than 60,000 people.

5. The No-deal mortgage
There are thousands of mortgage products out there, but in
How Long Should You Fix Your Mortgage For? I suggested that there are basically two different types of mortgage: The Deal and The No-deal. It's a little simplistic, but a good guiding rule.
If you have a deal, such as a tracker or a fixed-rate mortgage, so that you're paying close to the Bank of England's Base Rate, then that's great. However, if your deal has expired and you're paying your mortgage company's standard variable rate (SVR) then you are paying way over the odds for your laziness, probably thousands more each year.
> Get yourself a Deal:
compare mortgages.

6. Extended robberies
Extended warranties are a form of insurance that enables you to return goods that develop flaws within a fixed period, often three years. However, you usually get a free manufacturer's guarantee that lasts a year. Secondly, under the Sale of Goods Act you have some protection if there are problems with design, quality or reliability. Thirdly, you may be covered for accidental damage under your home contents insurance. Finally, the cost of the warranty can add well over 25% to the total cost!
If you save all the money you would have spent on warranties for your various products, you should have more than enough left over if the manufacturer's guarantee expires and you have to repair something or buy it again.
> Read
When Electrical Goods Go Wrong.

7. Invest with lots of stupid humans!
We often talk about Stupid Humans versus The Computer when we compare the performance of 'managed funds' (which have fund managers choosing shares to invest your money in) with 'index trackers' (which automatically buy all the shares in an index, such as the FTSE 100 or FTSE All Share).
Managed funds were lucky to escape this list. Index trackers kick their butt most of the time, largely because they are so much cheaper. (Read more in
Index Trackers vs Managed Fund?)
But there are funds out there which I think are worse than conventional managed funds. These are
'fund of funds', where a highly paid fund manager takes your money and invests in a selection of managed funds. The result will often be a pretty diversified investment, so you might as well as have just tracked the market, or tracked some overseas market via ETFs.
Instead, you have effectively tracked the market, but paid a lot more in management fees to various stupid humans, so your performance suffers significantly.

8. Crusty old current accounts
Most poor financial products are complex, but current accounts are as simple as it gets. Even so, much like mortgages, if you haven't switched in the past few years you're probably getting a shockingly bad rate of interest on your credit balances. You may be getting just 0.1% interest per year when you could be getting more than 6%. So stop dawdling and switch to a decent account.
Compare current accounts.

9. Any product that is advertised on TV!
There are so many financial products that fit into this category that I think it's more helpful to write a general warning. The cynical truth is that any product that is heavily advertised usually makes a lot of money for the advertiser. If it's making the advertiser more money, it means that it is taking more money from you.
You have to ask yourself why the product has such a big advertising budget. There are 'loss leaders' of course, where a minor product is offered to hook you in, but the best financial products are almost never advertised. This is firstly because these products sell themselves (e.g. the best current accounts) and secondly because companies don't want you to buy the cheaper products, because it usually means more money for you and less for them. That's why you never see index trackers advertised all over the place!

10. Another general warning
The main rule is that if you don't understand a product, don't buy it. When I say understand the product, you should not only understand its benefits and be able to compare them with other sorts of products, but you should also understand how the seller makes its money from it.
Everything about it should be simple to understand. If it isn't, it's probably because clever mathematicians have devised it to make companies a fat pile of cash.
The number of bad products out there is frightening so, as the Romans said, 'caveat Fooli': 'let Fools beware'!
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