Let’s take the example of mutual funds. Suppose a financially naive young couple hear the following pitch:
“A mutual fund is a pool of money invested by expert money managers in stocks and bonds. We have a collection of 5 diversified funds that returned 9% per year over the past 5 years. If you start contributing $500 per month into your RRSP and increase this as your pay increases, then a 9% return will give you over a million dollars in 30 years.”What’s not to understand about this? Our young couple will feel safe checking off the “make sure you understand the investment” item on their checklist. More experienced investors will know this couple doesn’t really understand, but the couple won’t know this.
Let’s try pitching an even more dubious product, index-linked GICs:
“The stock market has the potential for big gains and GICs provide safety. We’ve found a way to combine them to get the best of both worlds. If stock markets perform well, our index-linked GICs give higher returns than regular GICs, and if the stock markets crash, your principal is 100% guaranteed.”Again, this explanation gives the illusion of understanding to naive investors. More sophisticated investors know that there is hidden bad news in index-linked GIC interest formulas, but naive investors don’t know this. They have a nice tidy story that feels easy to understand.
The sad truth is that a lot of advice like “invest in what you understand” and “get a good financial advisor” is difficult to follow without more financial savvy than most people have.