Money tip #84 – Don’t invest in something you don’t understand

This may seem like an obvious concept but you’d be amazed at the number of people who don’t follow this bit of common sense, as i'll explain.

If you don’t believe me then you just need to look around at the newspapers. Among the catalysts for the financial crisis were mortgage-backed securities.

What are mortgage-backed securities?

In simple terms what investment institutions did was to initially offer mortgages and debt to people who realistically never had the means to pay them back. In the US this was particularly rife and as a result these bad loans, fuelled by the ease of credit availability, pushed up house prices while the economy merrily trundled on.

The lenders then took these loans (a lot of which were bad) and with a sleight of hand trick that any magician would be proud of created investments. The trick was to chop up these loans into tiny pieces and then combine them with others and so on and so on. These new products would then provide an income stream based on the underlying loans and these were then sold on to eager investors. The lending institutions erased the loan risks from their books, while the investors acquired an investment from a credit worthy institution which provided a handsome return. Everyone was happy.

As this went on and on you can see that investors (largely institutional ones) could own an investment and not realise what the underlying risks were because ultimately they didn’t look at the detail. Even if they did it would have been difficult to work out exactly what they were buying. In theory a person in the street could, in a rather long-winded way admittedly, own shares in their own mortgage without even knowing. How crazy is that?

Of course, when the people who took out the original loans, which they could never afford, stopped repaying them it all came crashing down and these mortgage-backed investments became worthless. The banks lost huge amounts of money, companies collapsed, credit dried up and so on and so on…….

The moral

So the moral of the story is that the devil is always in the detail. Worryingly a lot people in the finance industry (and not just financial advisers) don’t always understand the risks of what they are selling (by this I’m referring to investments available to the public). So what chance do their clients have?

Don’t let your vision be clouded by promised returns nor the simplicity of a product. Because ultimately that’s the beauty of any magician’s trick.

On that note, a lot of you may have received financial promotions from your bank or read articles about ‘structured products’. These ‘simple’ investments are gaining popularity due to their apparent transparency and the ‘protection’ they often provide from market downturns. But while they might have a place in an investment portfolio you, or indeed your adviser, need to fully appreciate the risks they carry.

So as a guide I will shortly write a post highlighting the problems with this type of investment. Until then….