A75-year-old man got a call from his bank manager begging him to take a loan against his mutual fund portfolio because the manager needed to meet “year-end LAS (Loan against Securities) targets”. A lady walked into my office having lost 40% of her money within six months from margin trades done by her broker. She wasn’t aware of the daily gains or losses being incurred or the high interest charges on the loan taken to fund the margin money. Another doctor friend asked if she should invest Rs5 lakh in a mutual fund. On probing, I discovered that it was a unit-linked insurance plan (Ulip) being mis-sold as a mutual fund. Yet another distressed caller lost all her money in a pyramid scheme her friend coerced her into.
Financial ignorance is profound in our country. Why do sensible, educated people still get entangled with snake oil salesmen and phoney schemes? Here is a checklist of things to look out for before you invest in a product.
1. If a scheme promises far higher returns than conventional investments, and demands that you act right away, failing which you will miss the opportunity of a lifetime, give it a miss.
2. Be cautious of guaranteed high returns with no risk. High returns come with high risk. Exponential returns carry risk of absolute loss of capital. If you continue to get high returns even when the markets are down, that is a huge red flag.
3. Be wary if your returns are consistently high despite adverse market conditions. It’s a classic sign of a ponzi scheme.
4. Check for exit options. How soon can you get back your money?
5. Find out the details of the scheme and how it intends to generate returns. What is the underlying asset it is investing in and historical performance? If an investment is being sold for a guaranteed return, ask to see the brochure where such guarantees are printed.
6. Check to see what you are signing up for. Often, products are sold as a one-time investment and investors are caught off guard when they realise the investment commitment and lock-ins are for much longer.
7. If you can’t understand the business model or if the promoter is ambivalent about how she will generate returns, then beware.
8. Ask for proof of legitimacy. Who are they registered with and who are they regulated by? Ponzi schemes are not regulated by any authority.
9. Ask for redressal options in case you lose your money. Ask them to explain what your worst-case scenario may be. Demand detailed reports of the transactions in the scheme
10. Get on the Internet and look for any legal or regulatory action has been taken against such entities.
Often, the lure of high returns makes people reckless. Sometimes a product with return guarantees, or a product whose cost remains the same every year may not be a good thing for investors. Let me explain.
Several insurance companies sell a “guaranteed NAV” Ulip. NAV is net asset value. People invest in this plan expecting to get the highest return from equity markets during the tenure of the plan. They couldn’t be further from the truth. If they examined the product brochure carefully, they will notice that the returns are inversely proportional to the markets. In a rising market, the portfolio tends to become more conservative to guarantee the current NAV, and vice-versa.
Clients often complain about increasing health insurance premiums. I tell them that if their premiums stayed constant, they will be at risk. An insurance company works on the law of averages. If the company pays out more money in claims than the premium it collects, it can’t sustain the business. If you pay a low premium and receive a high cover, then study your policy document closely. Your cover may be high, but is there a cap on some costs?
Some countries offer defined benefit pension plans, which guarantee a fixed return during an investor’s lifetime. But those plans are often unsustainable in the long run. In 2014, the US Congress announced severe cuts in the pension benefits of 1 million employees covered under the Pension Benefit Guaranty Corp. (PBGC). Since these plans committed a fixed return to investors, the only way they could pay the older pensioners was at the cost of newer employees, who fund the growing deficit by paying higher contributions.
In India, Provident Fund (PF) and Public Provident Fund (PPF) interest rates, though guaranteed by our government, are not fixed. The PPF rate, benchmarked to the 10-year government bond yield, has swung from 12% to 7.8% over the years.
If you are unable to make informed financial decisions on your own, seek the help of a financial adviser. She may lecture you on why you shouldn’t invest in another property, hector you about running up a huge credit card bill and badger you to trim down your expenses. I once heard someone say that meeting a financial planner invoked the same feelings of unease as a visit to a dentist.
All I can say is sometimes the experience may be like pulling out teeth, but if you can grin and bear it, you will be smiling the rest of your life.
Priya Sunder is director and co-founder of PeakAlpha Investments