Simplicity is the Ultimate Sophistication

01 March 2019

“Life is very simple,” Confucius once said, “but we insist on making it complicated.”

This is true not just of life but of investing. Many investors would be familiar with complex investment products that claim to produce higher returns. These products are usually only available to the rich, giving them an air of sophistication and desirability that may be unfounded. After all, it was these highly-engineered products and financial derivatives which were the primary causes of the 2008 global financial crisis.

Why then do so many financial institutions still pour time and effort into manufacturing and marketing such products? Are they truly motivated by wanting to give investors a higher return? Here are some other possible reasons:

A. It disguises the true risk.

With a stock or simple unit trust, you know that if the market goes up, you’ll make money. If it goes down, you’ll lose money. You can look up historical statistics to see how the product has fared in the past and get an idea of how risky it is. You can look at annual reports to see if a company is making money. It is easy to verify whatever your broker or adviser says.

This is not the case with a complex or structured investment. These are usually based on derivatives of other investments with embedded options, guarantees and trigger events. Few people – including those selling you the product – truly understand how they work, let alone the risks involved.

These products will try and tempt you with promises of high yields to distract you from dwelling too long on their risk. They will be accompanied with lengthy terms and conditions and lots of technical jargon that obfuscate what exactly you are buying. If the true risk of these products were more apparent, most investors would probably not buy them.

To make the threat more real, it was reported that several large financial institutions were fined by regulators for falsely assuring investors that its products were sound when they knew they were likely to fail – right before the Great Financial Crisis hit and proved their suspicions to be true.

B. Fees can be easily hidden

The fees and other costs for stocks and unit trusts are transparent and easily compared in the marketplace. This makes it hard for any financial institution to overcharge investors.

However, complex and structured investments are usually unique to the financial institution that created them. There is thus no way for investors to check if they are being overcharged. It is also difficult to tell what the actual fees even are, because the institution could easily embed many high fees within the product and then state that its upfront fee is low, or even zero! That way, fees are deducted along the way before the final return is shown to investors, (with a small or non-existent fee on top of that), giving investors the illusion that they are getting a good deal when the opposite may be true.

Researchers Brian J. Henderson (George Washington University) and Neil D. Pearson (University of Illinois and Urbana-Champaign and MIT) found that investors, on average, pay a premium of about 8% over the actual intrinsic value of such products! With such high over-pricing, such products are highly likely to underperform their underlying assets.

Bruce Carlin from the University of California Los Angeles (UCLA) wrote a paper showing how firms deliberately increase product complexity so as to make price comparison difficult, allowing them to charge higher fees without investors knowing.

C. Investors are enticed by such products

Ironically, another reason why financial institutions continue producing such products is because investors want them. Many investors are attracted to complex investments and specifically seek them out. In fact, the more complex a product is, the more an unsophisticated buyer is willing to pay for it.

Of course, the higher cost of a product means higher embedded fees and higher commissions attached, which gives relationship managers and distributors a greater incentive to sell them over traditional products.

But why are investors drawn to complex products? One reason could be the highly optimistic projections they offer, far above the market norm. However, researchers Carole Bernard, Phelim Boyle and William Gornall conducted extensive Monte Carlo simulations of the likely payouts and found that such projections were extremely improbable. In other words, there is no such thing as a free lunch.

Another reason could be how such products are a status symbol in themselves. The way they are portrayed as investment options for the wealthy can make investors feel like sophisticated and discerning investors who are able to afford access to those venerated financial institutions and banks.

D. People forget about risk

The true risk of any investment product always shows up at unexpected times, often bringing with it devastating consequences for the ignorant investor. After the 2008 financial crisis, many investors in complex products found that it was their worst case scenarios – and not the glittering promises of high yields – that had come true. This process continues to this day.

Remember, if something sounds too good to be true, it usually is. Always spend more time asking about and understanding its risk rather than its return. More often than not, your best option would be to stick to simple, easily understood investment instruments.

After all, to quote another philosopher (Leonardo da Vinci), “Simplicity is the ultimate sophistication”.

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