Let’s take the example of mutual funds. Suppose a financially naive young couple hear the following pitch:
“A mutual fund is a pool of money invested by expert money managers in stocks and bonds. We have a collection of 5 diversified funds that returned 9% per year over the past 5 years. If you start contributing $500 per month into your RRSP and increase this as your pay increases, then a 9% return will give you over a million dollars in 30 years.”What’s not to understand about this? Our young couple will feel safe checking off the “make sure you understand the investment” item on their checklist. More experienced investors will know this couple doesn’t really understand, but the couple won’t know this.
Let’s try pitching an even more dubious product, index-linked GICs:
“The stock market has the potential for big gains and GICs provide safety. We’ve found a way to combine them to get the best of both worlds. If stock markets perform well, our index-linked GICs give higher returns than regular GICs, and if the stock markets crash, your principal is 100% guaranteed.”Again, this explanation gives the illusion of understanding to naive investors. More sophisticated investors know that there is hidden bad news in index-linked GIC interest formulas, but naive investors don’t know this. They have a nice tidy story that feels easy to understand.
The sad truth is that a lot of advice like “invest in what you understand” and “get a good financial advisor” is difficult to follow without more financial savvy than most people have.
An interesting (if not impossible to enforce) would be those helpful "Nutritional Statistics" like information on every investment? Given most folks don't understand the Nutritional Statistics on their food, I have less hope that they would comprehend the data they need for their investments and savings.
ReplyDeleteAn interesting idea or concept I meant...
Delete@Big Cajun Man: Maybe something like the warning labels on cigarette packages would work for bad investments.
DeleteONLY if it includes pictures of homeless folks as well...
DeleteGood post. The investment industry relies on creating the impression that investing is very complicated and not easily understood. Investment vehicles like the kind you mention are then packaged to make it seem as if simplicity for the average investor can only be achieved by investing in such vehicles. After all, you probably don't get many clients (and/or fees) as an investment advisor telling folks to buy a few index funds and set up a GIC ladder. But I agree, you likely need to at least have some basic investing acumen to separate the proverbial wheat from the chaff.
ReplyDelete@Juan: Thanks. It seems that some simple things can be made to seem complex and some complex things can be made to seem simple.
DeleteI wonder how many energy/oilpatch workers have invested only in energy stocks and in housing in oil cities...investing in what they know and understand.
ReplyDeleteThey likely don't realize how completely correlated their investments are...and how much risk they have taken on.
@Garth: I was guilty of holding too much stock in two of my employers. It worked out well in one case but not the other. It took me quite a while to figure out that I made a mistake in both cases.
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