Did you experience a loss after investing in some unit trust?  Is your money stuck in some special deposits that paid higher interest rates but comes with certain conditions?  Did you regret buying that investment linked plan? Did you recently lose money in the stock market?  What do you do?

Simple! Blame it on that financial professional.  Financial planner, insurance agent, relationship manager, private banker, analyst, or stock broker, you name it.  They, in your opinion, are guilty of MISELLING JUST TO MAKE MONEY!!!

This article aims to analyze the financial professional and the investor and tries to answer this question, “Who is really at fault?!”

Am “I” Investing?

I sometimes overhear enthusiastic financial planners advocating their clients or potential clients to invest if they want to improve their living standards.  The logic is simple, put a dollar in today and it will grow to a larger number tomorrow.  “Why spend money on that car” they will advise, “when you can use that money to make money instead”. Though most of these financial planners will sound reasonable, their understanding of investing is often shallow.

From an economics view, we live to experience happiness (Oops! I did it again.  One reader once remind me that it is “satisfaction” but it is not an important argument) and one way of experiencing satisfaction is through consumption.  We feel satisfied when we eat or consume that pizza.  We feel satisfied when we use that handphone.  We feel satisfied when we own that watch. We feel happy when we donate to that needy (charity can be seen as a way to purchase happiness).  The measurement of satisfaction economist use is known as “utility”.

Items of satisfaction unfortunately don’t just fall from the sky.  Instead, we have to sacrifice something to gain that item – time or other resources.  By renting our labour to anyone who demands such labour, we sacrifice time that would have otherwise been used for leisure to earn an income to exchange for other consumption.

What does investing got to do with all these blabbering?  Well, a lot.  Since we live to consume, why then do we want to allocate monies earned into assets?

In theory, investing is the sacrificing or deferring of today’s consumption – by renting these resources, which you could have used for consumption, to others - for more consumption in the future.  How much will one defer will depend on the rental (or compensation) rate – also known as interest.

But I can hear the screams of some Oaktree critics, “what about those who have too much money?” The definition does not really deviate from the above except that the deferment of consumption is more involuntary than voluntary.  Why are consumption involuntarily deferred?  Incomplete product (and services) market is one cause - in other words, the market at that point does not provide what is wanted.

The question of whether to buy that car or invest the money into an asset is really not about the car being an expense – as accused by many – but a question of consuming now or later – also known as inter-temporal consumption choice.  One will tend to defer “consuming” the vehicle if the benefit is more than the cost of the deferment – the present value of tomorrow’s consumption is more than today’s.

What is the right level of compensation? Theory advocates that the compensation rate to an investor should be made up of two rates - a risk free rate for the deferment of consumption and a risk premium for undertaking risk of the asset choice (see articles on CAPM).  That’s why the insurance guy always tells you that you need to take more risk to earn higher returns.

The Investing Process

My explanation of investing – as a deferment of consumption - sounds so simple.  But in truth, the investment process in reality is not.  An investor would usually have to go through this investment process:

1. Self/Internal evaluation
2. Market/External evaluation
3. Portfolio construction decision
4. Construction execution
5. Review

But how do the investment professionals fit in this process?  The table below should give readers an idea.

So There Is No Wrong to Blame Them!

Base on the above, some readers will exclaim that it is thus not wrong to blame the financial professionals for losses they suffer after listening to their advice.  Of course not! Investment professionals are created from the demand to outsource the investment process but the investment decisions – the level of risk return ratio that the investor decides to undertake – responsibility is still that of the investor.

No one forced the investors to buy that fund.  No one dragged the investor to accumulate that share.  No one asked the investor to choose between the structured deposit and his life.  No one forced investors to sign the disclaimer.  All these decisions are undertaken by the investors who are aware of the rule of “caveat emptor”.

I Want the Gain but None of the Venture

I hear screams again.  “The financial institutions are developing products to cheat investors and their employees are mis-selling them!”  Complaining investors would probably cite products like structured deposits – which are sold as a safe way to earn higher interest rates as they are either fully or partially capital protected.  “They sell them as safe investment but now many are stuck with the deposit and earning returns below market rate!” is the probably complain of such investors.

We mentioned that investors are compensated for deferring consumption and undertaking risk when they invest.  But like any rational economic man, investors demand maximum compensation with minimum cost – shortest possible investment period and with the lowest possible risk.  I was once approached by a rich investor who snobbishly told me that he will finance him S$10m to anyone who can provide him a 20% return guarantee within a year, and I mean he wanted a credible bank guarantee or insurance bond.  I answered him “if anyone will give you a guarantee like that, I will sell all my assets, borrow on these funds, and invest every cent.  Than I will take that guarantee and convert it back into cash by issuing a return guarantee of 8%!”

Any common man will know that if you don’t want to risk capital, than your compensation rate for deferring consumption is simply the risk free rate.  There is a lot of timeless wisdom in the saying “Nothing ventured, nothing gained”. But how can the financial institution offer higher returns if nothing is risked? Well, such investments are structured to risk investors’ future returns instead of capital.

Structured deposits are basically created by investing in zero-coupon bonds (or discounted bonds) and than using the “left-over” funds to invest in risky assets.  The longer the deposit lock-in period and the higher the current interest rates, the more funds are left-over to undertake risky assets.  Early termination by the investor would mean having the institution reversing this position at a cost – which is transferred to the investor as a penalty.

Why would financial institutions structure such products? - Because there is demand for products that provide high interest rate and capital protection.  Financial institutions are profit orientated organizations and there is really no “sin” in providing products to market demand.  To emphasize product features, such as “high interest rates” and not returns, to attract attention is not unexpected in any marketing effort.  What rights does an investor have? - The rights to decide after considering the risk and returns (and I emphasize returns) of the product.  This right continues to hold even if the product is introduced by a financial professional.

So Think Straight and Hard

Investing is really no easy feat and therefore investors should be more vigilant when evaluating alternatives.  Do look out for that great advisor but remember that the responsibility of the choice is all yours.