Never purchase what you do not understand

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Financial markets would work better if we could be confident in the reliability of its products and the integrity of those who sell them. As the example of Scottish Life precipice bonds highlights, selling shares to customers who do not understand what they are buying is hardly a means to this end.

Why would anyone want to buy a bond whose return is proportional to the square of the current interest rate? Why would someone in search of high income buy a security that offers it, but also offers a risk of large capital loss if one of three stock market indices should fall more than 25 per cent below its initial level? Why would anyone looking for a guaranteed investment return accept such a return from a share whose only recourse for that guarantee is a portfolio that is itself invested in similar securities?

You should address the first question to Procter & Gamble, which bought a portfolio of these securities from Bankers’ Trust in the early 1990s. You should ask the second question of small investors in the Scottish Life international income and growth bonus bond who have just learnt that, although they received the guaranteed income, they have lost two-thirds of their capital. And you might put the third question to buyers of zero-preference shares in split-level investment trusts, on whose behalf Britain’s Financial Services Authority is now demanding compensation.

It is just possible that there are people out there who are wondering what they will do if the interest rate squared rises above a certain level. Or who want a secure return but, having sold puts on the Eurostoxx 50 index, must now hedge their bets. But it is not these people who bought these securities. The only good reason for taking these peculiar bets is that you have calculated that they are mispriced, the prospective returns outweigh the risks, and you are well enough off to invest a small fraction of your assets as part of a broad diversified portfolio.

But valuing complex derivatives such as these (and these are relatively simple as modern financial instruments go) is not easy. The process requires advanced mathematical models and access to long series of historic data. Not many people have these skills. Those who do earn large salaries from specialist firms, such as Bankers’ Trust, or the investment banks that created the over-the-counter derivatives behind products such as the Scottish Life international income and growth bonus bond. The only people well equipped to assess the value of these instruments are the people who are selling them.

It is always worth considering why I want to buy what someone else wants to sell. Sometimes there is a good answer. Toyota is very good at making cars and therefore has a lot of them. But this reasoning does not apply to speculative financial transactions where one side must pay what the other side receives. The essential nature of Bankers’ Trust’s trading programme with Procter & Gamble, precipice bonds and split level trusts, is that people who understood the products they were selling sold to people who did not understand the products they were buying. There was no other rationale.

Better information is the answer, but not in the way regulators often think. We could deal with food safety by insisting that those who sell poisonous food list its toxic ingredients on the packet, but this is not really a sensible: course: the warning will be in small print, or difficult to understand, or smooth-talking salesmen will persuade customers that the label does not really mean what it says. The main obstacle to the sale of poisonous food is not even prior regulation, but the knowledge that the outcome will be irreversible damage to the reputations of the businesses involved.

And so it should be in financial markets. That is why the Sykes report, on UK savings and investment, published on Tuesday, is entirely right to say that the central requirement is to re-establish trust and the central actors in that process are not regulators but businesses themselves.

In the meantime, the best advice is not to buy financial services products you do not understand: a maxim that has served Warren Buffett well enough. That maxim ought not to be necessary. I do not understand how my Toyota works, but I know that the manufacturer is reputable and plans still to be around when I buy the next model. Financial markets would work better if we could be as confident in the reliability of its products and the integrity of those who sell them as we are in the reliability of our cars and the integrity of those who sell them. It does not seem a lot to ask.

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