Greed is the name of the game

‘ we brought nothing into the world, and we cannot take anything out of the world. But if we have food and clothing, with these we will be content.But those who desire to be rich fall into temptation, into a snare, into many senseless and harmful desires that plunge people into ruin and destruction.’ (1 Timothy 6:7-9)

The recent disclosure of huge trading loss by a giant US bank shows how prevalent it is amongst the financial institutions to resort to “all about risk-taking” to generate profits. New and complex trading instruments are ‘created’ for trading purposes, and their trading positions can be so huge (to make that razor-thin profit margin) that they can cause turmoil in the financial markets.

The ex-head of equity derivatives business of another US giant bank, revealed publicly why he decided to quit his job. The interest of the client is often sidelined as the firm thinks more about making money. The culture which centred on teamwork, integrity, humility has vanished. The view of doing what is right for the clients even it may mean less money for the firm is no more popular. As long as you make big money for the firm is all it matters, and that guarantees your promotion to an influential position and fat pay checks.

Here is how a financial firm do it and do it fast by rippling the clients: Persuade the client to invest in the stocks or other products that the firm is trying to get rid of. This would help the firm to get rid of risks that no one want by selling those risks to someone else who does not know enough to know they should not want them. Another practice is get your client to trade whatever it will bring the biggest profit to the firm regardless of whether the clients are sophisticated or not to understand these products. The emphasis is on ‘short-cuts’, not 'long- term' business relationships. The mammoth monetary rewards encourage such practices.

Complex financial products are gaining popularity in Asia. Examples of some of these are Reverse Convertibles, Super Track Notes, Accumulator and Principal Protection Notes. Whatever names they may give to these products, they are essentially structured products and carry high risks. Take for example, the Accumulator, which is a contract that obliges investors to purchase a security, currency or commodity at regular intervals at a fixed price. This obligation lasts throughout the term of the contract, normally one year. Perhaps the most attractive feature of this product is that the fixed price is set at a significant discount to the prevailing market price. The trick or 'poison pill' is that if the security price drops, investors remain contractually obliged to purchase the underlying security, even the prevailing market price is lower. The contract typically has a clause which terminates the contract if the stock reaches a certain level, which is usually set slightly higher than the initial price. So the gain is capped in that sense. However, the investors could be required to double down on purchases if shares dropped, hence, the losses piled up with each purchase.

Investors apparently have not learn a thing or two from the financial crisis in the past. In fact, seeking to accumulate wealth by buying structured products is an unwise move. No companies issue securities to help investors. They do it for a single purpose-to raise capital at the cheapest cost possible. So if a security carries a high yield or potential future return, inevitably it entails a high level of risk, even if one can't identify the risk. If you cannot fully understand the products, then walk away from them, don’t invest. By the way, the complexity of the product is intentional so that if you understand the product, it is likely that you won’t buy it. 

Inflation

Inflation can be good to some but a bane to others. In Germany, due to the past experiences of hyperinflation, any form of debt, especially consumer debt, is frown upon by most Germans. The country’s saving rate was more than 10% during the period 2003 to 2009. For the same period, the Americans’ saving rate was merely 1.5%. The German economy has improved and is in much better shape after it went through a period of painful wage restraint and labour market reforms. Hiring and firing of workers are made easier while welfare benefits have been reduced.

The Germans hardly invest their money in stock market, but mostly in life insurance instead. On the other hand, stock market is important to US, that helps to explain why Wall Street is important to the policymakers. Fewer Germans owned houses, 41% compared to 66% for US. For this, inflation is good for the Americans because when housing price goes up, the value of debt will decrease. For the Germans who are mainly renting, inflation is bad for them. Hence, the Germans are generally more concerned over inflation than the Americans.

For Singapore which has enjoyed mild inflation of not more than 3% for the past decade, the spike in inflation in the past two years to above 5% probably explains why housing price has been skyrocketing for the same period too. For those who are renting, high inflation is a ‘poison’.

Financial Derivatives

"The plans of the diligent lead to profit as surely as haste leads to poverty."(Proverbs 21:5)

The recent financial trouble of a major financial derivatives broker again throws light on the risks of commodities and derivatives products. In an environment where it has becoming very difficult to make money based on stubbornly current low interest rates lent to clients, more and more financial institutions are taking on excessive risk and over-leverage to carry out their own proprietary trading. Making big bets on European sovereign bonds is one of them. These companies relied heavily on overnight loans to finance their operations which can be pulled at any time.

The Contracts for Difference (CFDs) are basically betting on the movement of an asset without actually owning it. They were first introduced to retail traders in 1990s and were popularised by a number of UK companies with innovative online trading platforms. The ability to trade on leverage (as high as 10 times the leverage ratio), and one can trade both ways (long or short position) are the main selling points of this product.

There are a lot of talks held over last few years which just as any other kind of ‘investment talk’, unfortunately focus primarily on financial gain potentials rather than risks. Now it is apparent that the inherent risks are not just confined to the financial instrument itself, but also the CFD provider. The CFD is always a contract between the client and the provider. It can trade under two different models, i.e. the provider is a ‘market maker’, or by way of ‘direct market access’. The ease of opening such trading account with a small cash outlay has enticed many novice investors over the years. This financial turmoil may help to bring us back to reality – that there is no free lunch in this world.

Caveat emptor (Let the buyer beware)!

“They conceive trouble and give birth to evil; their womb fashions deceit.” (Job 15:35)

It was reported recently in The Straits Times that since 2006 till now, there are 17 companies under suspension under the Stock Exchange of Singapore. I browsed through the names and noticed that 12 are China-linked companies. This does not reflect well the quality of companies that are attracted to raise funds here.

The China story was a very hot investment theme in 2005/2006 when many relatively unknown, small to mid- sized Chinese companies started to flock here through initial public offers. Prospectuses depicted fantastic profit growth rates and big plans. Many of them were brought here by the big brokerage firms which also underwritten these companies’ fund raising exercises. Such close relationships inadvertently led to very favourable reports from these broking houses. It was very common in those heydays that share prices of these companies opened at very high price (40-50% above issue price) on the first day of listing.

These Chinese companies started to raise even more funds through convertible bonds (normally of 3-5 year tenure) shortly after listed. I remember many of them were done in 2006, and the broking and investment houses made lucrative fees from such exercises. Share prices peaked around September 2007 and a year later came the financial crisis. When these bonds started to mature in 2009 and thereafter, these companies defaulted on the bonds, and the ‘true’ earnings started to surface.

I should say that many of my ex-clients lost more money in China shares than in other shares. In fact, one of my ex-client is so mesmerized with China growth story that he holds almost exclusively Chinese stocks in his portfolio despite advice. His refusal to act when things don’t turn out well caused him huge paper losses to-date.

If you ask me what is the most important thing to consider when investing in a company, I will say-corporate governance. In fact, there is a premium attached to a company that has good track record of corporate governance in that it commands higher valuation in the stock market. What is the point of a company making good profits when the top management is more concerned with their own pockets and even engaged in ‘milking’ activities? When the ‘ profits’ sound too good to be true, better take them with a pinch of salt. This is especially so for a foreign company where it is difficult to verify the information furnished. For novice investors, start with Singapore-based blue chips that are in the ST Index is a better choice.

Investment rules

“Wisdom is a shelter as money is a shelter, but the advantage of knowledge is this: that wisdom preserves the life of its possessor.”(Ecclesiastes 7:12)

Recently I browsed through a wealth management newsletter sent by a bank. One of the articles entitled `Avoid the most common investor mistakes’. Some of the pointers mentioned are planning, realistic expectations, cutting losses, avoid cheap and low-priced stocks etc. However, to me, after having worked in the financial sector for the past 12 years, the most valuable investment rules are ‘KNOW WHAT YOU INVESTED’ and “BE PRUDENT, AVOID BORROWING’.

Investing nowadays has become very complex, so be alert and not to be fooled by the ‘marketing’ materials which often disguised as ‘research’ materials. Do not be overdose on information which is so easily available that you can become paralysed by them, blurred your vision and drown you in useless details. Go for something simple and you can understand, rather than lured by the high `projected returns’. Preserving capital is the key in any investment.

The Lehman Brothers debacle in 2008 clearly illustrates the above investment principles. Investors suffered huge capital losses buying investment products which were paraded to the public as safe investments with attractive returns (not knowing that they are actually derivatives).

Thank God that none of my clients was hit by these derivative products. I had some clients who expressed keen interests in buying them. My ex-company was also one of the distributing channels. I browsed through the thick prospectuses and found them to complex to understand. At that time, there were many such products named themselves as ‘bonds’, been launched with big newspaper advertisements. Money from financial services sector was so lucrative that NUS Biz Adm’n undergraduate course received the most applicants and from the brightest in 2007.

The other thing that an investor should be mindful is be PRUDENT, avoid ‘gearing’. Invest only on money that you can spare and lose. A close friend told me that someone borrowed $200k from his bank to invest in Lehman’s bond. Yet another who is novice investor, tried to trade forex which is very risky as the gearing allowed is as high as 98% of the capital (you only need to fork out 2%).

In any investment, always work on the worst scenario, i.e. what is likely the maximum downside. Once you have done with it, the upside will take care itself because psychologically, most people know how to handle profit but don’t know what to do when their investment turns sour.

It is a very common practice for the sales staff to impress you with imputation of unrealistic projected returns during their presentation of the product. You should only pay attention to the guarantee returns, especially for insurance policy. Also, buy a ‘hybrid’ product such as investment-linked policy is not advisable. Such product will cause uncertainty to what you will get upon withdrawal or on maturity as the investment component in such policy can be very volatile, especially if it falls in a bad investment year.

Higher risk, higher return and vice- versa. There is no free lunch in this world. Do your homework. Keep track of your investments and be humble, learn from your mistakes. If you have no time to invest personally, then do it through professionals. Be very careful when someone offers you something that is too good to be true!