1. Value of Financial Advice - author Jim Parker
2. Risk Taking - Active v. Index Management - author Amy Horan
The article below was originally written by Jim Parker in February 2009 and has been reproduced with his permission.
Investors grappling with extreme market turmoil, as we have seen, often question the value of financial advice. Perhaps the more pertinent question to ponder is the cost of bad advice. That unrecoverable cost has been evident on several fronts in the past year amid revelations of multiple investment scandals, in which thousands of people have been robbed of their retirement savings.
Even properly advised investors found unprecedented market volatility difficult to deal with. But the pain was compounded for those who were victims of incompetence, deceit and, in some cases, outright fraud.
Among the accused was disgraced financier Bernard Madoff, who swindled investors of $US50 billion in a 'Ponzi' scheme, a scam in which early investors are paid with money from later investors. Clients are still trying to work out exactly what he did with their money after investigations revealed he never bought any of the blue chip stocks and Treasury bills he listed on their statements each month. No sooner did the Madoff case start to fade from the headlines, that it was revealed that another wealthy financier, Robert Alan Stanford, had been charged by US regulators with a $US8 billion fraud.
Stanford was accused of misleading investors by telling them their money was in unusually high-yielding certificates of deposit, when in fact the vast bulk of it was in illiquid real estate and private equity investments. Here in Australia, thousands of average people suffered devastating losses as a result of the $A100 million collapse of Storm Financial. Storm was an advisory group which shoehorned clients into highly-leveraged equity investments irrespective of their age, existing assets or risk appetites. Many of those clients not only saw their equity portfolios decimated, but lost their homes and businesses. Some were left owing money due to their margin loans exceeding the value of their investments.
In Japan, a flamboyant businessman named Kazutsugi Nami was arrested and charged with defrauding investors of $US2 billion, in a scam that involved him making promises of a 36 per cent annual return. A futon salesman by trade, Nami went as far as issuing his own money called 'divine yen'. Fellow schemers were alleged to have swapped this for goods sponsored by his company.
While each of these episodes is distinctive, they share a common characteristic, in that people were lulled into investing in something that, in normal times, might have seemed too good to be true. That's the nature of long bull markets.
People start to focus exclusively on return, rather than the risk which drives return. This provides an opportunity for purveyors of bad advice or plain scam artists to ply their wares. So it's worth reflecting at this time on exactly what constitutes good advice and how investors can recognise it when it is offered to them.
First, good financial advice is not about providing a forecast. The smartest advisers are not those who seek to divine what will happen next in the markets, but the ones who help their clients to make smart decisions about their money to secure the capital market rate of return. This kind of advice is not based on a hunch or guesswork, but on financial principles backed by long observation and research.
Second, good financial advice is about structuring an investment strategy that is right for the individual, not one that reflects what the adviser is trying to sell or what will earn them the most in fees and commissions. It has to match each person's appetite for risk, while helping them reach their investment goals.
Third, good financial advice is about ensuring clients' portfolios are structured around risks where there is an actual relationship with return. The scandals listed above largely resulted from people not understanding, or not being told, the sizeable risks they were taking in chasing 'guaranteed' returns.
Fourth, good financial advice means ensuring investors understand what they are investing in, and that the management of those assets is handled transparently and with a great deal of integrity.
Fifth, good financial advice involves advisers being upfront with their clients about what they can and can't control. If investors want to enjoy long-term equity returns, they need to be exposed to the equity market. That means they can't avoid being exposed to a market downturn. However, they can ameliorate controllable risks such as fees, taxes and their degree of diversification.
Sixth, good financial advice means keeping investors disciplined in their chosen asset allocation even when things seem hopeless. Good advisers remind their clients that falling prey to short-term anxiety, and dumping their asset allocation to shelter completely in cash, may not best serve their longterm wealth. It just means they forego equity market returns and are placed at risk of missing the bounce in risk assets when it comes.
For the victims of the likes of Madoff, Stanford, Nami and Storm there is little or no chance of retrieving their original capital, save what they might secure in a class action. Some have lost everything. By contrast, investors who have been advised properly have plenty of reason to hope. Their diversified portfolios may be down, but they can take comfort from the fact that potential returns are now at extraordinarily high levels and that, if they keep their nerve, they are positioned for the recovery when it comes.
That is the value of good advice.
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