When the Parliamentary Joint Committee on Corporations and Financial Services handed down its recent report into Financial Products and Services in Australia, it was predictably lamenting how ‘mum and dad’ investors lacked the educational skills to critically analyse retail investment products.
The lengthy report says: “Recent catastrophic investor losses (Storm Financial and Opes Prime) demonstrate that many investors do not have the expertise to filter poor financial advice using their own knowledge about sensible investing.”
The report continued: “Many retail investors do not understand the nature of investment risk and the importance of spreading risk across diversified asset classes, instead relying on third parties to steer them in the right direction. As was made apparent during evidence to this inquiry, many investors seek financial advice for the very reason that they have minimal financial literacy, and therefore place complete faith in the investment advice they receive.”
Clearly the committee, chaired by Labor backbencher Bernie Ripoll, was deeply worried about this lack of education. It only made 11 recommendations, of which one was: “The committee recommends that [the Australian Securities and Investments Commission] develop and deliver more effective education activities targeted to groups in the community who are likely to be seeking financial advice for the first time.”
But is education the answer? Will more sophisticated investors be less sceptical of the ‘snake oil salesman’ who comes dressed in a pinstripe suit? Unfortunately, history suggests the answer is ‘no’. Because what is hardly mentioned in the Ripoll Inquiry is the role that investors’ desire to rapidly increase their wealth for little effort – or, to be blunter, plain greed – plays in these financial implosions.
All financial advisers have experienced the difficulty of managing clients whose tolerance for risk varies with the direction of the market. This changing risk tolerance is motivated by the desire to maximise wealth quicker than a sensible allocation of resources and cash flow allows.
For the sake of the argument, let’s look beyond Australia’s shores to some prime examples.
First, the Nigerian letter, or, as they are sometimes known, the ‘419 scam’ (the number 419 refers to the article of the Nigerian Criminal Code dealing with fraud). We all get these e-mails, and most immediately press the delete button. But some don’t, and according to authorities, they’re mostly professional people.
Who could honestly believe that a complete stranger was simply going to drop $12 million into their bank account? Quite a few, actually. A comprehensive report in the Canadian newspaper The Globe and Mail, estimated that for every 1,000 scam e-mails, one or two people get taken in. Some of them are well-educated doctors who have even made the trip to Nigeria to evaluate the opportunity.
There can only be one explanation for this: their greed for an easy dollar simply results in the total suspension of any common sense. This is a common occurrence.
Then there’s Bernard Lawrence Madoff, the former chairman of the NASDAQ stock exchange, who has pleaded guilty – and been sentenced to 150 years’ jail – to a massive ponzi scheme, possibly the biggest fraud in history.
His client list read like a ‘who’s who’ of Wall Street. These were not mum and dad investors, they were sophisticated, well-educated investors – many working as investment advisers at the institutional end of the market. If anyone should have seen the flaws in Madoff’s scheme, it was these investors.
But they were lured in by the fact he was always promising – and delivering – a return on investment. Where was the scepticism that says no investment manager always gets it right? Investing is cyclical and that Madoff’s investment strategy, no matter how sophisticated, could not be immune from this reality.
Flags had already been raised in the investment community about a decade ago, but those who attempted to do proper due diligence were denied and he continued to raise funds. In the end, it’s estimated the total amount missing from client accounts was almost $65 billion.
The Storm Financial implosion has been well documented. There have been endless stories about how these unsophisticated investors fell prey to Storm Financial offering a one-advice-fits-all solution for clients seeking to rapidly increase their wealth. But I have little doubt they were lured to Storm because of the offer of a higher return in a bull market. Many, I suggest, saw other financial planners who suggested boring strategies such as diversification and a conservative approach (if any) to leveraging their portfolio. But these strategies were not exciting enough – the lure of a swift financial gain was just too attractive.
History is littered with such examples, which have affected well-educated, sophisticated investors as well as mum and dads. You can go back to Tulip Mania in 17th century Holland, the South Sea Bubble in 18th century England and, more recently, the investment by banks in collateralised debt obligations to find greedy investors. Parliaments can pass all the laws they like; they will never be able to legislate against greed.
Ironically, the main bulwark against greed, and ideally the main source of investor education, are financial planners. But they are being tainted by government inquires, isolated cases of abuse and a press-seeking sensational headlines – a classic case of throwing the baby out with the bath water.
George Lucas is managing director of the boutique asset manager Instreet Investment Limited.