What do the following investments have in common?
- Covered calls
- Collateralized mortgage obligations
- Non-traded REITs
- Master limited partnerships
- Variable annuities
- Equity-indexed annuities
- Hedge funds
- Principal protected notes
- Private equity
Here’s the answer: They are all complex investments. As a result, assessing the risks involved with owning these investments can be challenging. They also generate meaningful commissions for the brokers who sell them so enthusiastically.
Brokers benefit from complexity
Brokers love complex investments. They give them the opportunity to demonstrate their “superior” knowledge. They also reinforce the message that you need them to guide you through the intricate world of investing.
Few investors understand complex investments. The securities industry wants to keep it that way. One study concluded that “producers of retail financial products create ignorance by making their prices more complex, thereby gaining market power and the ability to preserve industry profits.” The same study found investors “often make purchases without knowing exactly what they are getting or how much they are paying. In fact, they may also be unaware that they are indeed over-paying.”
The lack of knowledge about complex investments is shrewdly exploited by the securities industry. For instance, some experts believe structured products are almost never suitable for retail investors.
Opt for simplicity
Intelligent, responsible investing does not have to be complicated. Market returns are yours for the taking (less low management fees). Here’s an example. I’m not suggesting it’s suitable for everyone.
What if you invested all your retirement and non-retirement assets in Vanguard’s LifeStrategy Moderate Growth Fund (VSMGX)? This fund holds 60 percent of its assets in stocks, a portion of which is allocated to international stocks, and 40 percent in bonds. It’s broadly (and globally) diversified. It rebalances automatically, so your risk profile never changes. It has a very low expense ratio (management fee) of 0.14 percent.
Since its inception on Sept. 30, 1994, the fund’s average annual return has been 7.49 percent.
Think about that data. Your account statement would consist of one line item. You could easily determine your return for every quarter and over various periods of time using Vanguard’s website.
There are, of course, other options available for investors who want to customize their portfolio and still keep it simple and understandable. The three index fund portfolio I recommended in The Smartest Investment Book You’ll Ever Read has withstood the test of time. I summarized those recommendations in this blog.
Dealing with pushback
You need to be prepared for pushback from your broker when you discuss the benefits of simplifying your investment life. Remember that brokers thrive on opacity. The less you know, the better it is for them.
Few investors understand their brokerage statements. I believe in some cases they are intentionally formatted to make it difficult or impossible to elicit critical information. Here are some questions to ask your broker:
- Since the beginning of my relationship with you, what has been my annualized return, net of commissions and other fees?
- How much risk am I taking in my portfolio?
- How much have you earned from my portfolio since you started managing it?
- Because I can easily and inexpensively capture the returns of the global marketplace using low-cost index funds, shouldn’t you be compensated only if my risk-adjusted returns are in excess of those returns?
You are unlikely to get straight answers.
In investing, complexity is the devil.
This commentary originally appeared May 10 on HuffingtonPost.com
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