Buying complex retail investment products

Date published: 21 December 2012
Author: Greg Ford

21 December 2012, Brussels 

In the butcher’s shop you see two options:  one says 90% lean beef, the other says beef with 10% fat. Which do you prefer? Most people would say the “lean” beef, even though the two cuts are identical. Psychologists call this “framing” and this particular sales technique is as common in retail investment as anywhere else.

According to a recent EC study, people’s financial behaviour tends to rely on “intrinsic psychological attributes rather than information or skills” and is heavily biased by cognitive and emotional factors. Sales techniques such as “anchoring” and “framing” are commonly used to exploit this.

At a time when retail investments are getting more complex, this is a worrying finding. The products of financial engineering are on sale at nearly every high street bank but instead of becoming more rational as consumers, the report shows we are as soft-headed as ever.

image of human head as jigsaw puzzleThis is why the EU is looking at legislation to simplify and reduce the technical jargon that accompanies such products and has made some good (but modest) proposals in the area.

Packaged Retail Investment Products, or PRIPs, include complex products ranging from the confusingly named “equity bonds” to products built up with exotic derivatives or other financial instruments normally reserved for professional traders. For more on this market and to see Finance Watch’s recommendations to improve the proposals on what retail investors should be told before buying a PRIP, see our recent position paper, “Towards suitable investment decisions?”.

The difficulty for regulators is that, as the research shows, consumers make investment decisions for the oddest reasons: we follow advice from people we trust regardless of their motives or financial expertise – such as the salesman on commission or the share-tip from a friend. One in three of us simply picks the most familiar product, and one in 20 picks the first thing we find. In many cases, this is our main way of saving for retirement!

Even those who understand the products may have difficulty assessing the risks attached, especially for complex products. It is one thing to have a stern warning in the small print saying that investors could lose money if their provider’s counterparty goes bankrupt but quite another to expect retail investors to go out and identify the counterparty and then judge if they are creditworthy. Even credit ratings agencies and large banks struggle to get this right.


Finance Watch has recommended that these new and complex investment products have the same level of consumer protection as simpler products. Among other things, we would like to see a ban on features that are not suitable for retail investors, for example complicated components whose pay-out is very difficult to predict.

We are also recommending that vendors be more upfront about hidden costs. The beauty of structured products – if you are a bank – is that retail investors have little idea what they cost to assemble. Products built from components, for example a bond and a derivative bundled together to give a certain outcome, can be sold together for more than the cost of the parts. A typical example might be a product that pays you a guaranteed 1.5% interest a year for five years (the bond component) plus half the rise of the stock market over the same period (the derivative component).

It is normal for wholesalers to add a margin but customers still need to know what they are signing up for. Like fees, embedded margins can have a big impact on final performance and are, in effect, a part of the cost of owning the product. Such margins are not paid in cash by investors but are financed through a reduction of the potential return: for example instead of buying a product offering 50% of the future performance of a stock index, you will only get 30% of the future performance of the index. As the margin in hidden, the end investor will never know about it.

Finance Watch wants providers to disclose the “theoretical margin at maturity” of the structured products they build. This figure is already calculated by product manufacturers to set prices, so it would be easy to disclose and would help consumers to keep the market honest.

A final aspect of PRIPs is their impact on society. Investments backed by retail savings finance a huge part of the real economy and many retail investors are happy to think of their savings funding jobs and factories. This cannot always be said of PRIPs, which can sometimes be more of a financial bet than a true investment (for example, a product linked to the gold price or the rate of inflation).

We are used to seeing the salt and fat content of food products disclosed on the packaging but there is little equivalent in the investment industry. The market for packaged investment products is huge – EUR 9 trillion in 2009 – so it seems inevitable that there will be some impact from their “salt and fat content” on the real economy. Finance Watch is therefore recommending that PRIPs be labelled as either an “investment” or a “bet” so investors can decide for themselves whether their money is used in the real economy or not (for more on the difference between investing and betting, see page 20 of the position paper).

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