07 May Thieves and scoundrels
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It is only natural for investors to question, particularly when markets fall and their portfolios do the same, how valuable financial advice really is. After all, they still pay fees even though they have lost money, so their losses are compounded.
However, perhaps it is more appropriate to consider the cost of bad advice. By ‘bad advice’ I am not referring to advice, given in good faith, to invest in something which later fell in value. No-one is blessed with the ability to see that accurately into the future – if they were, you can be sure that they would not be still working for a living. Rather I am thinking of the number of instances in which investors have been robbed of their savings by unscrupulous crooks who cynically exploited their clients’ trust to line their own pockets.
I was reminded of this recently while reading Frederick Forsyth’s autobiography. Despite his self-confessed ignorance of financial matters, the author of ‘Day of the Jackal’ and several other highly successful novels had done pretty well for himself from writing after an eventful career in journalism. When on holiday in Israel in 1977 he met a financial adviser and subsequently invested most of his assets via him, albeit with established and reputable institutions. That individual was Roger Levitt. In 1990, he discovered that Levitt’s firm had gone bust and with it, his portfolio; it turned out not to have been invested as claimed at all and like the investments of many other of the firm’s clients, had instead been misappropriated to support Levitt’s business. Despite having extracted £32m from those who had trusted him, Levitt managed to get off with 180 hours of community service after pleading guilty to two trivial offences of misleading the then financial regulator. While this rated as a pretty big deal for the UK at the time (particularly for those who had been ruined by Levitt), the case paled into insignificance by comparison with others which subsequently came to light elsewhere in the world.
To date the greatest (if such a term is not offensive to those whose claims to greatness are based on more worthy criteria) of these is the US financier Bernard Madoff, who stole around $50bn from investors by running a Ponzi scheme. His crime was aided by what appears to have been considerable ineptitude on the part of the Securities and Exchange Commission, the US regulator, which failed to respond adequately to various tipoffs over a number of years to the effect that the returns he was claiming were not achievable.
Madoff was not alone – Robert Stanford, who was charged with a fraud amounting to around $8bn not long afterwards, apparently claimed that his investors were buying certificates of deposit, albeit ones with high yields, which are close to cash in terms of their security. In reality, their money was going into illiquid and risky private equity and property investments.
Of course such crimes are not restricted to across the Atlantic. Some investors in Japan were unfortunate enough to encounter Kazutsugi Nami, whose promises of annual returns of up to 36% were supported by issuing his own currency. Losses amounted to $2bn.
Despite each case being unconnected, what they have in common is that those who were duped were persuaded to buy something which, had they stopped to think more closely, might have seemed too good to be true. It is particularly easy to fall prey to such blandishments when markets have been on a prolonged upward trend and people focus more on the potential returns than on the risks.
So what is good advice and how can you recognise it when it is offered?
It is emphatically not about forecasting the future. The best advisers recognise that this is largely guesswork and therefore focus their attention on helping their clients to make sound decisions which will give them the best chance to achieve the returns available from the market.
They understand and make it clear to their clients what is within their control and, more importantly, what is not. If you need (in order to accomplish your goals) to achieve the long term returns of equity markets and can accept the associated risks, then you need to invest in those markets. The inevitable consequence of this is that when the markets experience a downturn, you will too. What an adviser can control is the extent to which you are exposed to those risks, how diversified you are, what costs you pay and, to an extent, what taxes you pay.
It is also about putting in place and monitoring a strategy which is aimed at achieving the client’s own objectives with a degree of risk with which they are comfortable and can afford to take. This may involve the adviser earning less than they otherwise might, for example by retaining more cash in deposits, repaying debt or investing in assets such as properties.
Then there is the selection of the underlying types of asset in the portfolio. All investments have some form of risk but not all risks are equal and not all are compensated for by an expected performance return. A good starting point when looking at what is a reasonable expectation is to look at the return available from the debt issued by sovereign governments of countries with good credit ratings. Governments have the huge advantage of being able to print money (notwithstanding Nami-san’s claims to do the same) to repay their debt, which increases inflation and so reduces its real value. While this can have other unwelcome consequences which makes most wish to avoid this measure, it does tend to reduce the risk of default. Such information is available in most of the broadsheet national newspapers and the number to look for is the redemption yield on issues whose time to maturity is consistent with your own time horizon. The redemption yield takes account of both income and capital return, so is a measure of the total return that an investor would receive over that period.
When inflation is low and not expected to increase significantly, government bonds, whose return is fixed, become more attractive so their prices rise as more investors choose to buy them. As the price goes up, the redemption yield falls. Consequently UK bonds are currently offering fairly low annualised returns, of the order of 0.08% for five years and 0.22% for 10. If any investment in supposedly low risk assets is offering more return than this, there is probably something fishy in that there is a risk that is not being disclosed. There are no investments which provide high returns with low risk. If there were, everyone would buy them, their price would rise and so their future returns would fall.
Good advisers also ensure that their clients understand what they are buying and take the trouble to explain how they work. They employ managers who operate transparently and within the regulations and where they use a custody service to handle the administration of a portfolio, they use a custodian which is independent and substantial enough to weather any market turbulence.
They also recognise that at times, the economic environment will be challenging and the future can seem hopeless. In such situations, helping to illustrate how ditching a long term plan in favour of switching to 100% cash is unlikely to be in their clients’ interests. Sudden falls can be followed by similarly sudden rises and those investors who baled out in panic are much less likely to be able to capture the bounce if it comes.
Of course, investors who fell victim to one of the fraudsters are faced with little chance of recovering their investment. Unusually, the Madoff recoveries have been remarkably successful, with $14.3bn recovered so far, which amounts to over 70% of the approved claims. However, many investors in such scams are not covered by investor protection schemes and if they have borrowed to invest, they could face losses greater than their original stake.
By contrast, those who took good advice will likely have portfolios whose value have fallen but when prices fall, potential future returns increase and simply by holding their nerve and getting on with their lives, they are positioning themselves for any future recovery. Surely that is where the value of good advice becomes apparent.