What To Ask Before You Buy A Financial Product

There is one question to ask before you buy any financial product. It's obvious, when you think about it.

This article was first sent to Fools as part of our The Good, The Bad and The Ugly' email campaign.

When you see a financial product that seems interesting, the most important question to ask is: 'Where's the catch?' When you can answer that question, you can work out if the product is any good.

With personal loans, the answer is easy. The bank gives you some money, but you pay it back with interest on top. Thus, the bank makes money. Not the most devious of catches.

Savings accounts are a little more clever: you give some money to the bank, and it pays you a little interest. It then lends your money to someone else at a higher interest rate, and so it makes money.

Now, let's take a look at a more complex product. It doesn't get more complicated than guaranteed equity bonds, so we'll take that one. A guaranteed equity bond (GEB) is a stock market-linked product with which you invest for a fixed period, typically five years.

The benefits, as they're described by the providers, are:

• You are guaranteed not to lose money. You will get your entire investment back even if the stock market goes down.
• If the stock market goes up you will get all the returns on the growth in share prices. Not only that, but they will also give you an extra 15% on top.

Wonderful, huh? What's more, there are usually no charges for this product.

So where's the catch?

To work that out, we must pull apart what the providers call the 'benefits'.

If the stock market goes down...

Let's start with the guarantee. Firstly, if the stock market goes down, you get your entire investment back. However, you have lost money. Quite a lot in fact. This is because inflation (the increasing price of goods and services) makes your money worth less over time.

Let's say you invest £10,000 and the stock market falls after five years. Because of the guarantee, you get back your £10,000. However, let's say that, during that time, inflation ran at about 3%. So after five years, with your £10,000, you could only buy as much stuff as you could do with £8,600 today. Effectively, you have lost £1,400.

If you'd put your money into a top savings accounts, you could have matched or slightly beaten inflation. Even better, if you'd used cash ISAs (tax-free savings accounts), you could have kicked inflation's butt, perhaps returning well over £10,000 in today's prices.

If the stock market goes up...

'Ah, but!' you're thinking. 'But, Neil! What about that extra 15% they promised, eh?' Oh dear.

Let's say that the stock market goes up a modest 10% over five years. You get all the profit from this, so your investment goes from £10,000 to £11,000. Plus, you get an extra 15%, as promised. However, this isn't 15% of £11,000, as you might expect, it's only 15% of your profit. And as your profit was £1,000, you get an extra £150, making your total return a healthy £11,150.

Amazing, right? Wrong.

You see, when you invest in the stock market, you can make money in two ways. The first way you know already: share prices go up. Secondly, many companies pay you an income once or twice a year from their profits. This is called a 'dividend'. What the GEB providers fail to spell out to you is that they keep all the dividends. And so we finally establish how they make money, and the biggest catch.

Not receiving the dividend is a huuuge problem that I cannot stress enough (but only because technical problems won't allow me to put in more 'u's).

Let's say that, instead of buying a GEB, you invested the same £10,000 directly into an index tracker, which follows the stock market. Let's assume once again that the stock market goes up 10% over five years. Index trackers have annual charges though, so, after costs, your £10,000 has gone up to about £10,700, which is £450 short of the guaranteed equity bond.

However, I haven't added in your dividend. Let's say that each year you've received an average dividend of about 3%, which is quite a typical return over the past five to ten years. After the first year, you receive an extra 3% on your 10,000ish pounds. That dividend is reinvested in the index tracker. You then get 3% the next year, and the year after, and so on...

Note that the 3% dividend is on the entire amount invested, not just on the profits (unlike the GEB). Because you've added your dividends to the pot, your £10,700 return leaps to £12,700. You have made £2,700, or 27%. This compares with the £1,150 (11.5%) in the GEB. In other words, you've received well over double.

Those figures I mentioned earlier (beating cash 75% of the time over five years and 93% over ten years) are based on the assumption that you get a dividend and reinvest it. If you invest without a dividend (e.g. in a GEB), your odds of beating a safe savings account or cash ISA are massively diminished.

With a guaranteed equity bond, you still have the bulk of the risk of the stock market, but you have a much lower chance of beating savings accounts. You also have a much higher chance of losing money, after taking inflation into account.

The dividend is vital if you want to make decent money from the stock market over the long term. I say, if you're not receiving the dividend, don't bother being in the market.

I'm afraid there's one more thing...

GEBs are, as you may have guessed, very complex products devised by clever mathematicians to make financial companies a lot of money without you even realising it. These products hide a few more tricks; one other of these is worth a brief mention.

The way GEBs calculate the start and end prices of your investment in the stock market is dodgy. Often they will use the average price over a week, month or year, rather than simply using the prices on the day you buy the product and the day the product expires. Whilst this helps to protects investors from falls in the stock market, it can considerably reduce your returns, particularly if there's a big rally in the fifth year.

This means that if the stock market went up 10% (as in the above example) many providers wouldn't calculate it like this. If much of the gain was in the last year you'd be lucky to get more than £11,000, rather than the £11,150 you'd expect. And so they skim even more money off you!

Guaranteed equity bonds are an abysmal financial product, and they are deeply unFoolish.

If something sounds too good to be true, ask yourself: 'Where's the catch?'

> Stick to cash ISAs and index trackers.