Too good to be true…again

More money is probably lost between the boundaries of reality and hype than is lost in total to fraud.

And so the reins of the “Too good to be true” thread have passed to Jon Chevreau.  First, before we dive into the fog, there are two things I want to make clear:

  1. One is that an ordinary investor should not, in truth, be the one primarily responsible for picking up on a too good to be true, or not, investment.  That is what an adviser or “advisor” is for, no matter how trim the definition of the latter.  The only instance where the first port of call for responsibility should lay with the investor is with direct DIY purchases. But for transactions and advice with regulated adviser/”advisors”, the first rally point should be with the adviser/”advisor”.
  2. Two, too good to be true can be anything where reality is likely meaningfully, and knowingly so, different from the “promise”.  There are many ways of embellishing a product’s attractiveness that would if compared properly against other alternatives, history and the risks of reality, make the product’s outcome appear markedly different.

Even in today’s limited suitability rollerball derby, I would have thought that too good to be true falls directly into the path of know your product and adviser/”ors” should communicate this to their clients. 

An adviser/”or” should not be allowed to promote an outcome that does not accord with the reality of the investment, the reality of the market and economic cycle, or to be more precise an outcome which fails to acknowledge the boundaries of risk and return and the consequences for breaching them.   

It is here that we must also level a finger a) at the brochures, messages and hype that the industry is allowed to deliver over and above the sultry black and white tones of truth, and b) the banal regulatory disclosures that generalise and de-personalise risk and return. 

At present you do not need to recommend a best interests investment, but this should not allow the adviser/”advisor” to represent the best and least realistic version of the truth for the products they recommend.  I would have thought that disclosure needs to be sufficiently comprehensive to allow those investors who want to take responsibility for the investment decision to arrive at a correct assessment of risk and return.  However, not  every individual will have the technical proficiency to decipher the more technical details of an investment.  In the absence of an honest appraisal, and/or the ability to spot the too good to be true, many a shade of too good to be true will be sold with consequence.   Perhaps we need a history of the product to be written to allow investors to tie consequence and outcome to promise and promotion.

In order to ground a recommendation in truth, where the investor’s own experience in such products is lacking, the adviser/”or” needs to inform the client about the historical margin of long term risky returns above lower risk assets, the often adverse reality of the short term risks of risky asset returns, the impact of costs and fees on return and, with complex products, at least, the structural impact of a security/product on the portfolio.  But alas, this is likely beyond the ability of most “advisors’” service processes to deliver and the ability of most investors to properly process and to inform.  I know minimum standards (KYC) make investment experience a factor in product selection, but I doubt whether it is an effective factor, and I do know that is often manipulated to the product seller’s advantage.

Some investors are suited to a transaction based system, but arguably, most are not.  At a fundamental level however, even basic suitability standards cannot be delivered without complete product transparency and information about product impact on portfolio structure, and hence product relationship with other assets and financial needs and risk.     

Many products would not be sold if an element of too good to be true, or a failure to represent the too bad, were not part of the package.  In a sense this ability to sell products without adequate transparency lies at the heart of the inability of the limited suitability standards that frame the transaction business model to actually deliver “investor owned” suitable transactions.  

The system is flawed and asking “the right questions” will never be sufficient for most  investors to gain the upper hand.  Anita Anand’s comments in a recent interview with Rob Carrick suggest that many academics, lawyers, regulators and “investor advocates” do not fully understand the working mechanics of a transaction based “advice” service process,  and how the weaknesses of such a framework in practise will forever invalidate it.  

Investors, in general, will never be able to take responsibility for the investment decision in today’s transaction based industry because a) the necessary transparency about the product does not exist and b) because even if it were, most would be unable to understand the information to make a decision.   

And so, really we come back to issues of fiduciary type duty, at a wider level, and the need to operate in the client’s best interests and, at a narrower transaction level, the requirement to ensure that the transaction is in the client’s best interests. 

Operating in the client’s best interests puts the onus on the “advisor” to make sure that every product and security is included in a portfolio of assets at its risk/return/cost/structural impact face value.  Even a best interests standard for the transaction would force the “advisor” to make the first call on the too good to be true aspect of the investment, leaving the investor to make the informed decision over the generics.  But, clearly, given that a best interests transaction system requires an investor intellectually and knowledgeably able to make informed decisions about securities and portfolio structure, it will not in of itself be sufficient to effectively regulate those relationships where the investor is reliant on the “advisor” and the service commitment is much wider than the transaction.

The too good to be true moniker could actually be applied to the financial services industry as a whole. Jon mentions Madoff’s returns, but long term risky asset returns (expected major market returns) close to the 10% boundary were also proffered by many MPT academics at the height of the dot com bubble, when it should have been clear that valuations were very very high.  I am also sure that the assumption that markets are efficient and that prices properly price risk was also a too good to be true assumption, and one could argue that this helped create a complacency about risk and return that many in the industry took advantage of.   Mutual funds sold with high annual expense ratios are also too good to be true investments given historical long term risk premiums over bonds.

Current regulation of suitability standards and its codes, rules and processes are incapable of delivering the transaction and no amount of vigilance on the part of the ordinary investor can realistically change this outcome.

More money is probably lost between the boundaries of reality and hype than is lost in total to fraud.

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