Wednesday, July 27, 2016

Aren’t the Banks the Investing Experts?

I listened to a few young people discuss where to go for help investing some savings and one asked whether the banks are the right experts. After all, they handle all the money. Wouldn’t they know more about investing than anyone else? It has taken me a while to think of a reasonable answer.

It’s true that Canadian banks have massive resources and could probably use them to try to generate above-average investment returns. However, they have little incentive to do this with your money. It’s so difficult to beat the market with a massive portfolio that it’s not worth their effort to try very hard.

Banks have an obligation to their shareholders to seek profits. They make money on assets under management. This means they focus on getting your money in the door and keeping it there. Generating above-average profits for you only helps the banks a little, and trying to do so is expensive. All they really have to do is avoid terrible returns so you won’t take your money elsewhere.

When you invest with a bank, they add your money to their mutual funds, GICs, etc. and it becomes part of the massive pool they dip into periodically to add to their profits. You may imagine them working feverishly to invest all this money wisely, but in reality they devote much more effort to drawing people in to invest more money.

One positive with banks is that they are relatively safe. Not perfectly safe, though. Mutual funds do lose money, and GIC interest often fails to keep up with inflation. However, banks are unlikely to outright steal your money. Unfortunately, every investment they offer contains unreasonably large fees that few people understand well.

It’s not just the banks that focus mainly on pumping up their assets under management. Much of the mutual fund industry is the same. But there are exceptions. The challenge is that you need to learn on your own to be able to distinguish a good investment approach from a poor one. You also need to to be knowledgeable to distinguish a good financial advisor from a poor one. I don’t know any shortcuts to finding a good way to invest your savings.

8 comments:

  1. MJ - While I agree with the gist of what you're saying, I'd make a few changes. Banks are experts at money *intermediation*, not *investing*. They are experts at taking in money people don't need every single day, packaging it up, loaning it to people/companies who do need money -- all in a way that those who provided the money can safely get it back whenever they ask for it (bank accounts) or when promised (GICs). While the system sometimes screws up (e.g. the financial crisis of 2008/09), by and large they do it quite well. But they don't have the opportunity to really be *investors* since they have a very low risk tolerance for all that money. As would you and I in their circumstances. Suppose we had $50k of our own money, and someone gave us $950k, of which they could ask for $750k back at any time, and the remaining $200k on a prescribed schedule over the next 1-3 years. We'd be extremely limited in what types of genuine investing we could do with our $1MM total "investment portfolio".
    To make money investing and become good at it, you have to have a time horizon that safely allows you to take some amount of risk thoughtfully. And some push/benefit to doing so. Change the thought experiment: to our $50k, a stranger adds $950k, only requiring we pay her back $1.25MM in 10 years time. Now we have 10 years to take a bit of risk, and we need to, since we have to come up with $300k=1.25MM-950k more over that time period, and any extra is ours to keep. No we have incentive to become good investors. (Those numbers mean we need to make 3% annual return, by the way). That's why pension funds and other "institutional investors" become good investors, better than banks.
    By the way, "investments" other than GICs our bank offers us, such as mutual funds, are a very different kettle of fish. If we sign on the dotted line, the bank doesn't actually get our money -- they just pass it on to the relevant money manager on our behalf. The bank in fact loses the ability to loan it out on others, and makes money only on the fees or commission it charges to us, or kickback it gets from the money manager, who charges us fees. However the mechanics work, those fees tend to be high because of the convenience factor, and since enough people are unsophisticated enough to be willing to pay them rather than look elsewhere. Sort of like paying a premium price for Dasani bottled water at the mall food court, even though the same bottled water is available for less at the Loblaws at the same mall, and the bottled water is just treated tap water anyway.
    (The banks do a better job than this; I'm overdramatizing. But there's little fundamental reason they should be *good* investors or provide good investment *advice* to us, and all sorts of reasons they can generally get away with being average or mediocre at it. What they do need to be good at is judging the creditworthiness of people and companies -- and surprise, surprise, they are. Which -- oversimplifying again -- is why e.g. landlords use credit ratings computed by the broader financial services industry to decide if to rent you and apartment, for instance.)

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    1. @Martin: I'm not sure we're saying much that is different except that I was trying to give an explanation accessible to novices. One difference is that I don't bother to make a distinction between a bank and the money managers for the bank's mutual funds. They are separate entities, but it's not as though the bank is powerless in the relationship. Money managers of bank mutual funds hug indexes to avoid bad years because that's what the banks want done.

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    2. You are forgetting one important fact:

      1) banks are required to hold a mere 11.5% in capital reserve (up until now it has been 0% -- not a typo).

      Banks know there is a very low probability of a shock of massive withdrawals of deposits, so yes, they can and do take risks with deposited and newly created capital, regardless of time horizon.

      Banks don't operate for centuries by being inept at playing the money shell game. They are in it for as much profit as possible -- always remember, banks are not a public service, they are corporations. MJ is spot on in that their only incentive is to keep your money in their institution, not to generate market beating returns for you.

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  2. I'd think a bank could do quite well marketing a fund that had actually outperformed (for valid reasons). However the inflow of money they would receive would quickly overwhelm the opportunity.

    Any truly exceptional manager can only work with a limited amount of capital and it's not yours. If they work for the bank the bank will take the whole profit instead of just a fee and use deposits for leverage if necessary.

    Another reason banks may not offer exceptional investments is that they just don't have to. When people are willing to lock in to a 5-year GIC with an interest rate barely above inflation, why bother?

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    1. @Richard: Having a mutual fund that performs well is definitely beneficial for a bank. However, this is hard to do through skill. It's just not worth the effort to commit resources to outperforming when there is a low likelihood it will work.

      Outperforming due to luck is as good as doing it with skill, but it comes with the danger of lousy returns due to bad luck. It's more profitable to just hug the index with the majority of mutual fund investor dollars.

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  3. When I went to sell my house I asked at the bank how to invest my money. The gent told me I'd need to speak to my accountant. Needless to say I was somewhat surprised and then found great blogs like this. Thanks, Michael.
    Ron B

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    1. @Ron B: That's a curious reply from the bank. I hope things work out for you. I know I learn quite a bit from reading other blogs.

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