Dunces with dollars

By BRENT SHEATHER

The organisation that regulates Britain's personal investment industry is increasingly alarmed by many investors' financial ignorance.

The Financial Services Authority says understanding is being held back "by the very low basic skill levels in numeracy and literacy of many adults".

A survey published in November found that nearly seven million adults (21 per cent of the adult population) had numeracy skills at "entry level 2 or below" - lower than expected of 11-year-olds.

Examples of financial literacy skills include understanding monetary values presented in different formats, and making value-for-money judgments of different products, which may involve comparing percentages and understanding graphs.

The survey assessed skills across a range of topics. The "entry level 2 or below" group did best on questions about money, but only half the group answered questions about charts and tables correctly and only a fifth got the right answers to questions about fractions, proportions and percentages.

The authority is right to worry - there is a lot at stake. Governments and companies worldwide want to extricate themselves from the responsibility of providing for the retirement security of individuals. But if people collectively blow their savings, governments will have to pick up the pieces.

There are other indicators which suggest that private investors' knowledge and skills are not up to speed. One is the number of people who leave long-term savings schemes early.

The FSA says: "There appears to be a lack of awareness of the costs of surrendering or lapsing investment policies. Shopping around can pay dividends, but only the minority of cases of people who stop paying into long-term investment products (around 10 per cent) represent people switching from one provider to another. Some policies' charging structures can penalise investors who stop payments early. Of those who lapse but do not switch, there may be some who are opting out of investment products for the longer term."

The authority, like Herald columnist Mary Holm, also worries that people are "over-optimistic ... about the safety and performance of the residential property investment market".

It laments that the 2001-02 bear market in shares made too many mums and dads over-conservative, leaving their savings in low-risk investments, which may not return enough to provide for retirement.

What market research there is on the subject is not encouraging; Britain's Fleming Investment Management recently surveyed private investors, with one of the questions relating to the biggest investment issue of all - asset allocation.

Just a third of the participants understood the phrase; some believed it referred to "the distribution of muscle around the body". Another survey of members of corporate super schemes showed that a third of the members did not know if their scheme was defined benefit or defined contribution.

Here in New Zealand, the authority's view seems to have some merit. Compare the variation in the price of investment management and advice with the price of petrol for example - a drive around Auckland will show that most of the major suppliers price petrol within a few per cent of one another.

Try selling unleaded gas at three times the price of your competitor down the road and it would be a scandal - you would more than likely appear on Fair Go - yet that is exactly the situation in the fund management industry here, in Australia and in Britain.

For example: Australian Foundation is a fund listed on the local and Australian sharemarkets which provides active management of a portfolio of Australian blue chip stocks for a fee of about 0.2 per cent a year.

Most of its competitors on both sides of the Tasman charge five or 10 times as much, and regularly underperform it as well.

Yet the expensive funds far outsell Australian Foundation. Why? The simple answer is that the market is inefficient, relying on the principle of "caveat emptor" when in reality the buyer is blissfully unaware.

If buyers don't know, understand or care about the price of a product, the industry can become choked with otherwise uncompetitive companies, which in a more rational world would go bust.

In New Zealand we have many unit trusts with only a few million dollars in assets. No economies of scale there.

And on the subject of investment knowledge, the media are not blameless either - a few years ago the chief executive of one "fund manager of the year" made the ridiculous statement that "a fund's returns were independent of its fee structure" and investors should look at the returns after fees.

That sort of reverse logic might have worked when markets were rising by 20 per cent a year but it sure doesn't work in more normal times, yet the paper printed the story verbatim.

And what of those hundreds of highly qualified financial planners and stockbrokers the industry churns out each year? Won't they inject some realism into the market? Not likely, especially if they want to stay employed.

The sad fact is that most of the theory gets forgotten in the execution. The industry regularly produces investment plans which wax lyrical about the efficient markets hypothesis and the benefits of diversification, then recommends six or 10 individual stocks to cover the New Zealand or world sharemarkets.

Worse still, some preach the "balanced" approach, then nominate five high-risk finance company debentures as the supposedly low-risk side of a balanced portfolio.

The fund management industry in Britain is nervously awaiting the authority's next move. It appears to be saying that if the financial services markets cannot discover the right price of active fund management for itself, the authority will take on the job.

Its report contains a thinly veiled warning for financial services companies: a cap on management fees is coming, so get your house in order and your costs down or you won't stay in the industry for long.

Five rules to follow

What can you do to improve your financial skills?

A good first step is to ensure that you are not intimidated by technical information and jargon. A good financial strategy is usually 90 per cent common sense and 10 per cent specialist knowledge. Of course, if you have no common sense you have a problem.

Be wary of any adviser or product you don't understand. Usually the more complicated a plan the more expensive it is.

And remember five key rules:

1. Diversification over different products and sectors is your best defence against ignorance - yours and/or your adviser's. In other words, some bonds, some property and some shares. Individuals almost always over-estimate their tolerance of risk.

2. Fees are absolutely critical. Investments which lock you in usually have the least attractive fee structures. And remember that there is no such thing as "no fees".

3. If it sounds too good to be true, it probably is. Forget most seminars; they usually push current investment fashions because that is what is selling now. If you are looking for something for nothing, your best bet is usually an employer-subsidised super scheme - if your employer offers one.

4. Most investments will be more risky than money in the bank, therefore they should pay dividends higher than bank rates.

Be very sceptical of investments which have low yields. Yes, I know this strategy means you would not have bought shares in Microsoft when it started - but you wouldn't have bought them in 2000 at the height of the tech mania either.

5. Ask your friends what they do and if they are happy. Put some effort into researching what you are going to buy. This doesn't mean you need to graph share prices or read annual reports - mostly that is a waste of time, unless you enjoy it.

What it means is that if you are going into a managed fund (and you probably will be, bearing in mind rule 2) read the investment statement and the prospectus.

You will need to ask for the latter as advisers usually provide only the investment statement. If there are any "hooks" in the product like high fees, they will more than likely be disclosed in the prospectus, but you need to find them for yourself - don't rely on the person getting the fee to disclose them.

* Brent Sheather is a Whakatane investment adviser.