27 June 2013
Simon O’Grady CFA, Chief Investment Officer at Gareth Morgan Investments
“…There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don't know. But there are also unknown unknowns. There are things we don’t know we don't know.”
United States Secretary of Defence Donald Rumsfeld on the ‘evidence’ for weapons of mass destruction (WMDs) in Iraq, 2002.
Sadly there’s a long list of dodo NZ finance companies and deceased investment funds that have been foisted on NZ investors who weren’t aware of what they were getting into. What this shows is that the wise words “there are things we don’t know we don’t know” apply equally to investing as they do to WMDs.
For many of these failed investments, the courts have concluded that the people running them (or entrusted with their governance) were, at best, grossly negligent and – in several high profile cases – simply criminal.
So how did so many everyday New Zealanders get swindled out of their money? And what can they do to prevent it happening again?
It all comes down to something best described as the ‘information gap’ – the things we don’t know we don’t know.
The investing information gap
As human beings we generally want to trust people. Most of the time this works out just fine, but every now and then we run into a charlatan who possesses something that we don’t have – information – coupled with the will to exploit it.
When everyday Kiwis invest money with investment professionals they are immediately at an informational disadvantage, so it’s no real surprise that at the heart of most of the financial catastrophes there has been a significant information gap. Investors simply didn’t know – and often didn’t have any way of knowing – what it was that they didn’t know. For instance:
- Finance companies
Investors didn’t know that the finance company they put their savings into was essentially a mezzanine debt-financing vehicle for property developers; a house of cards waiting to collapse in the next ill economic wind.
- Ponzi scheme gurus
Investors didn’t know that the impressive investment manager guru who had been delivering, say, a 30% annual return for the past five years wasn’t really investing the money at all, they were spending it.
- Complicated credit funds
Investors didn’t know just how complicated the ‘safe’ fixed income fund was, most being bamboozled by the technical terminology (how about “a levered, second tranche of a structured mortgage-backed SIV with a short option embedded”?) Nor did they know that the adviser who suggested it was being paid a hefty upfront commission by the fund provider.
Some lessons from the past
In my 25 years in the investment industry, I have personally had the dubious distinction of several first-hand experiences of fraudsters. Two stand out in particular which illustrate this knowledge gap.
One was my second job as a back-office bank jockey. A genial colleague owned a luxurious apartment and sports convertible… that turned out to be funded by a clever trick he had conjured up in the bank’s general ledger system. The fact was that he knew a lot more about how the ledger worked than the auditors – he had exploited his informational advantage.
The second was where, in a fiduciary capacity on the investing side, I was given a slick presentation by a currency fund manager, chock-full of charts and performance track records, backed by two major Australian banks. All very impressive indeed but something didn’t quite ring true – it was all just too perfect. Sure enough, a year or so later the manager was made a special guest of Her Majesty. The presentation, the numbers, the track record, the clients were ENTIRELY MADE UP.
In both cases (and anecdotally this is fairly typical), the perpetrators were articulate, convincing, likeable… and lying through their teeth.
Good financial advisers and investment managers close the gap
While various regulatory bodies are busy creating a web of costly rules and regulations to try and catch the bad eggs, the real solution lies deeper than this. It requires advisers and investment managers to truly buy into the principle of fiduciary duty, which is a values-based conviction that the investors’ interests really do come first.
A good financial adviser or investment manager truly believes that they are bound by duty and is committed to helping you bridge your personal investment information gap.
How to close your own gap
- Find an adviser who is committed to transparency.
- If you don’t understand what you’re investing in, then ask questions until you do.
- If your adviser can’t explain to you in plain language what you are investing in then they probably don’t actually know – get another adviser.
- If people sound like they are avoiding the question it is probably because they are avoiding the question – find out why.
- Engage with your investments – don’t just leave it with the adviser or manager and forget it. Read your reports and ask if you don’t understand anything. Keep on top of what’s going on.
And most importantly:
- Don’t be embarrassed to ask – ever. It’s your money and you are entitled to ask as many questions as you like until you understand. Of course you don’t know everything – that’s why you are talking to an adviser in the first place.
The information provided or any opinions expressed in this article are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your personal circumstances from an Authorised Financial Adviser before making any investment decisions.