Spelling it out: financial literacy and high-risk debentures

At the most fundamental level, individuals and their families live out the consequences of their financial decisions. This is particularly true in the case of investments. If the investment performs there are usually few complaints, but if it fails the law rarely delivers full compensation.

One of a democratic society’s goals must be to ensure that its members have the ability to make informed decisions in relation to how the risks in financial products match their needs and circumstances.

The first limb of this lies in product disclosure and the second in an investor’s financial literacy.

The base literacy for an individual’s properly informed commitment must include two critical personal perspectives.

Firstly, an understanding of how they would cope financially if the investment fails in any way. Secondly, an understanding of their financial risk tolerance so they can judge if they are taking on more risk than they would normally accept.

These terms are often described as the two primary components of personal financial literacy.

We have seen a progressive privatisation of the wider social welfare system in Australia in recent years.

This is best exemplified by the notion of ‘user pays’ in the supply of what were once government services and the transfer of responsibility for retirement funding and investment risk-taking to individuals through superannuation.

Financial planning for individuals and their families is growing evermore complex.

For instance, the combined impact of increasing longevity and insufficient retirement funds is putting into play the family home as a financial asset.

Personal responsibility for very difficult decisions is being thrust upon many who are ill prepared for them.

The benefits that come from a universal confidence in the integrity of the financial system are clearly a government, the Australian Securities and Investments Commission (ASIC) and community priority.

Confidence encourages investment and fear limits it.

So the ongoing failures in the unregulated debenture market are a grave concern.

While this market is relatively small, it has proven to be most vulnerable to mis-selling. It’s not hard to accept the argument that this is merely the tip of the iceberg and, as the world’s stock, property and fixed interest markets show increasing volatility, more surprises and frauds will emerge.

Insights from Financial Literacy — Australians Understanding Money, published September 2007, give no cause for complacency.

The report’s findings tell us that that there is a high level of personal confidence in individual decision-making.

Of the 7,500 participants in the survey, 88 per cent said they can recognise a scam in an investment scheme and 69 per cent said they have the ability to invest money, but only 34 per cent would consider both risk and return when choosing an investment.

If ever there was a recipe for financial disaster, this is it. We can at first flush be comforted by the revelation that 70 per cent said they are interested in learning more about investing money, but should be disconcerted that 30 per cent think further financial education is not worthwhile.

In the recent boom in property, equity and fixed interest markets, few investors have suffered adverse performance. It’s not so much that the notion of risk has been forgotten, it’s just that the lessons of the past have never been learned.

Behavioural finance researchers call this an optimism bias. There are only two ways to deal with unsubstantiated overconfidence — through real world-gravel rash or education.

How did high-risk debenture investors make their decisions?

Two of the important questions that need to be answered are:

> Why did these people, so obviously in need of good financial planning and portfolio construction advice, choose to go it alone?

> Why did they not seek financial planning advice first?

Financial planning is mostly provided by well-paid specialists, mainly for the well off and pre and post-retirees with larger lump sums of money.

In concept and cost it is not suitable or available to the vast majority of the community.

Clearly, the current advice system leaves significant numbers in the community at risk without access to the relevant education, tools, insights and/or advice necessary to make good financial decisions.

Putting personal investment decisions into context

We can better prepare ourselves for the challenges and vagaries of life if we know both our risk capacity and risk tolerance.

If we use an analogy from the health industry, an understanding of our individual fitness level and blood pressure will be a good indicator of whether our involvement in the City to Surf race should be as a competitor, walker or taxi passenger.

The failures of Westpoint, Fincorp, ACR and so on illustrate three issues.

First, the risks inherent in the offerings were at best not adequately conveyed to intending investors.

It is highly probable that investors thought they were investing in a higher yielding term deposit rather than as equity participants in a property development. They were taking development risk without the concomitant return.

Secondly, it’s clear that many investors did not have the financial resources to cope with the loss and, thirdly, many investors were traumatised psychologically by the loss.

We need potential investors to recognise that there is risk inherent in all investments.

Can a financially unsophisticated reader understand descriptions of the investment risks in Product Disclosure Statements?

We invariably read more carefully when we are looking for something specific.

So we need potential investors to read offer documents with the intention of answering at least one question, ‘How will I cope when and if this investment goes wrong?’. This sets the scene for their critical reading.

It is by focusing on the down side consequences to themselves and their families rather than the optimistic ‘better than bank returns’ that they can review the offer documents subjectively.

Knowing their financial risk capacity is a necessary insight for all investors, but more so for self-directed investors.

The first insight is one of risk capacity.

Many potential investors do not have the financial resources to cope with their loss.

Risk capacity is “the ability to sustain a less favourable financial outcome from an investment without derailing the original goals and strategies”.

For example: Retirees Bill and his wife Mary have $100,000 in a bank term deposit. Bill sees an advertisement in the Sunday paper offering a 2 per cent per annum higher rate from a reputable sounding organisation.

Currently, they spend all of the interest earned from their bank term deposit on living costs. An extra $2,000 per year would significantly improve their lifestyle.

They plan to leave the $100,000 capital to their invalid pensioner son Bob to use as a deposit for a home. I

f either the income failed or the capital was lost, both their short-term and longer-term plans would be derailed.

A potential investor needs to ask: “Am I investing more than I can afford to lose in any investment?”

In a practical sense, a potential investor must be able to say: “This is a risky investment, but I can afford for it to fail without the loss significantly changing my life plans.”

Knowing their financial risk tolerance and how it compares to others is an invaluable personal insight for all investors, particularly the self directed.

Many investors are traumatised psychologically by any financial loss.

The trauma results from being outside one’s risk comfort zone. Financial risk tolerance is: “The extent to which an individual chooses to risk experiencing a less favourable outcome in the pursuit of a more favourable one.”

This is no remote academic definition; it is a decision requiring significant personal engagement.

To return to Bill and Mary: Losing any or all of the capital and/or reduction of all or part of the income may severely impair Bill and Mary’s future pleasure in their retirement.

At the least, they will not be able to do some of the things they enjoy and will have less opportunity to take advantage of the range of life options available to them.

At worst lies the very real prospect of depression and anxiety, which might express itself in any one or mixture of the medically defined behaviours.

Risk tolerance is an important factor in financial decision making.

Risk tolerance affects not only how psychologically receptive individuals are to decisions involving risk, but also the degree of stress and anxiety experienced in situations where risk is evident.

A comprehensive risk tolerance test takes less than 15 minutes and can deliver an accurate assessment.

Properly informed commitment shown on the application to invest

All applications for investment should require direct investors to sign-off on questions about their risk capacity.

Similarly, all direct investors should have an understanding of their financial risk tolerance. They should sign off in their application for investment that they understand they are accepting risks that are either consistent with or greater than their risk tolerance.

The three statements direct investors in high-risk investments need to make on their application are:

> I understand that I can lose some or all of my capital and may receive part or no income.

> The consequences of the loss will not substantially impact my present and future plans.

> I accept the risk in the investment and understand how it compares to my risk tolerance.

If they cannot make these statements they should not invest.

The three statements drill down to the core issues of informed consent. An investor who signs off on all three has taken responsibility for their actions.

Not just words but actions

To help with financial education I have built a platform to help individuals personalise and build context for their financial decisions.

The suite of ‘ready for’ assessments will include both financial events and issues.

> Events will include retirement readiness, inheritance, buying a house, marriage and divorce.

> Issues will include high-risk debenture investing, home equity release for the over 60s, choosing a super fund and do I need a financial plan?

Using the four learning styles of hear, read, view and do, the issues addressed will be personal and relevant.

The assessments will be accessible from multiple sources. They will take no more than three minutes to complete and will be in simple language.

The initial self-assessment tool designed to assist those thinking about investing in higher yielding ‘debentures’ can be seen at http://highreturns.forus.com.au

Please go to the site and test the assessment, I am keen to get feedback on how it might best be used.

Paul Resnik is co-founder of FinaMetrica. This has been his summary of a submission to ASIC in relation to Consultation paper 89: Unlisted, unrated debentures — October 2007. Contact Paul at paul.resnik@ finametrica.com.