“Whoever commits a fraud is guilty not only of the particular injury to him who he deceives, but of the diminution of that confidence which constitutes not only the ease, but the existence of society.” – Samuel Johnson
I recently sat with Andrew Duvenage, the MD of NFB Private Wealth Management, in what proved to be a highly interesting conversation. It was sparked off by two recent, high-profile instances of alleged fraud within the South African financial sphere, adding to what feels like an ever-growing list. Fidentia, Masterbond, the Tannenbaum saga, Bernie Madoff, Enron, Steinhoff… the list goes on and on. Even though security has been tightened, technology has improved and even stricter regulations have been put in place, perpetrators do not seem to be put off in the slightest.
Unfortunately, it’s the honest people who suffer the most. Trust is destroyed – and without trust, [financial advisors] don’t have jobs. It’s a topic worth exploring – and definitely one worth solving.
The first issue: risk and reward are inextricably linked
One thing that’s quite common in instances of fraud is risk and reward. Investors are often promised unrealistic outcomes – but high reward comes from taking a big risk. High returns comes from high risk, yes, but one must be willing to take on high risk with a long-term horizon. While there are available investments that give investors those kinds of opportunities, investors really should invest according to their risk profile – because when those pyramid schemes show up disguised as a guaranteed exorbitant return, warning bells should already be going off.
“The question that we should all ask is why these investments are ‘offering’ this outcome and who is guaranteeing it? If there is no risk, why do these opportunities require our capital? If the outcome was such a ‘slam dunk’, why is this windfall being shared with us? Why wouldn’t the proprietors of this opportunity not simply go to the banks and raise the funds themselves and keep the benefit? The reality is that the higher that the promise of return, the higher the risk involved in the investment. While such high-risk investments may play a role in one’s portfolio, we cannot divorce ourselves from the reality of risk and return, and in many cases, this is where investors go wrong. The promise and allure of sublime outcomes (especially in the context of a struggling market with benign returns) makes one ignore a simple question: ‘Is this too good to be true?’”
The second issue: ‘betting the farm’
Every now and again, we’ll see investors putting all their eggs in one basket when an ‘opportunity’ promises great returns. However, diversification is an important part of the financial world; there’s a reason the saying goes: ‘Don’t put all your eggs in one basket’. In fact, get a different basket entirely for investments. No opportunity is worth investing your entire life’s savings and all assets in one fell swoop.
“In many instances, fraud is perpetuated through the following mechanism:
- An opportunity which seems too good to be true is presented.
- Investors commit a small amount of capital to it (testing the water).
- The opportunity delivers on its promise (either yield or capital is returned as promised) – all looks good, roll on the good times.
- The investor now has proof of concept, and starts to ignore the ‘risk-return’ paradigm, and jumps in boots and all.
Sadly, we know how this story ends. If one reflects on this all-too-common occurrence, the lesson is that investors should not commit more than they can afford to lose to speculative opportunities.”
The third issue: the nature of investments
We can make a case study on the most recent instance of (alleged) fraud, currently playing out in the financial services industry. From what we can see, a trusted advisor convinced clients to exit highly-regulated investments (unit trusts) and put the funds into unlisted, unregulated investments. These unlisted investments were positioned as offering sublime ‘guaranteed’ returns.
“Once again, there are simple lessons or warning signs here:
- Does the investor understand the risk implicit in unregulated investments and is it appropriate for investors to move into this environment?
- Who is guaranteeing this sublime outcome and why are they sharing this windfall with anyone willing to invest?
- In the worst-case scenario (implosion), what can be committed to such an opportunity without compromising one’s financial wellbeing?
This is not to say that all unlisted investments are bad. Many investors have made their fortunes from such opportunities. The point is that the lack of regulation increases risk, irrespective of how ‘safe’ the investment is purported to be. Investors need to fully understand this and question whether it is appropriate for their specific circumstances. The level of diligence with unlisted investments in respect of legal contracts, shareholder agreements and the like, far exceeds what is required for regulated investments, where checks and balances are built into the process.”
The issue of trust
As an industry, our biggest asset is the trust we earn. If that’s broken, we don’t have a business. Trust, however, is a two-way street: clients trust us with their finances and expect our honesty in where those finances are going; we, similarly, trust that our clients will be honest with us about their finances and where their funds came from. When that, or any trust is abused, there’s a good chance it’ll leave a reasonably-sized dent in the industry; clients will lean toward mistrust and that makes it very difficult for us advisors to carry on business as usual.
“Strong advisory relationships are built on deep interpersonal relationships and high levels of trust. While this trust should be earned, it is not something that should be unquestioned. Blind trust is often at the core of many of the issues that we see. While investors may choose to trust and delegate many administrative matters to trusted confidants and advisors, they should never forget that the ultimate responsibility is theirs. At times, uncomfortable questions need to be asked. Information needs to be validated. Explanations need to be provided. Warning signs should start flashing when an advisor is offended or defensive around reasonable questions or is unwilling or unable to verify requested information.”
To end off, it’s fundamental for financial advisors to practise with honesty and integrity. Our clients’ needs should come first and we should be 100% open and transparent with them. It’s important that we provide our clients with enough information to help them make an informed decision and provide them with the highest quality service we can muster.