JUNO INVESTING ©

Beware of the wolf: how to invest safely

JUNO INVESTING ©
Beware of the wolf: how to invest safely

 

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SPRING 2017

By Martin Hawes

He may be well-dressed, well-spoken and have a great investment to offer you, but can he be trusted? Martin Hawes explains how to invest safely.

All investment is about trust. When you make an investment, you have to give your money to someone else. And when you do that, there is always a chance that you might not get it back again.

To invest, you have to trust a range of people: your advisers, your bankers, the person selling you an investment – and you even have to trust yourself, by trusting your own judgement.

It’s very difficult to assess trustworthiness. Both Kiwi David Ross of Ross Asset Management and American fraudster Bernie Madoff gave every appearance of respectability, honesty and competence. But both proved to be running Ponzi schemes and many investors lost a lot of money. 

People who look the part, sound the part, and even act the part may not be worthy of your trust or your money.

Trust really is the most important thing for investors – and misplaced trust is one of the biggest causes of investment losses. But how do you decide who to trust?

Who not to trust

We all get unsolicited calls or emails from people trying to sell us ‘investments’ of some sort. These might be an email from Nigeria asking for our bank account number, with a US$5 million reward for you. These scams have been around for decades and have caught many people.

Alternatively, it might be someone from the Philippines selling some ‘cheap’ shares in a stock that nobody has ever heard of. This stock is ‘on the move’ (“a major announcement will be made next week”) and you had better get in now to make your fortune. 

There are plenty of other ways these kinds of people will relieve you of your money – scammers are endlessly inventive.

The people who fall for these kinds of scams are not just the naïve and inexperienced – all sorts of people, including high-profile businesspeople, have been ‘had’ by scams of all varieties. 

What to look for

There are three main features of investment scams:

1. They offer a very high rate of return.

2. The minimum amount you must invest keeps on reducing. When they first approach you, they may say the minimum amount to invest is NZ$50,000, but they will lower that amount to NZ$10,000 or NZ$5,000 if you’re not showing enough interest.

3. They need an instant decision – you must do it now, which gives you no time to think or take advice.

Beware of any offer that has these features – there’s a good chance it is a scam designed to take your money.

What is trust?

Trust is always the name of the investment game. Adviser Charles Green and former Harvard Business School professor David Maister have researched this area extensively , writing a book called The Trusted Adviser.  

These authors came up with a useful formula for explaining how to assess trustworthiness and decide who we should trust. 

The formula is a fairly simple one and looks like this:

 
Beware of Wolf Formula.png
 

Trust is built on three factors: credibility, reliability and intimacy. The higher someone’s score on these three things, the more we trust them. 

However, as well as these three factors that build up trust, there is a very important factor which sharply decreases how much we should trust someone. That is called self-orientation.

Note that the three things that build up trust are added together. Then, the total amount of trust generated by these three is divided by the perceived self-orientation of the person we are considering.

To explain these four factors a little:

- Credibility comes from whether the person has good qualifications and is experienced in their industry.

- Reliability concerns whether they turn up on time or do as they promise.

- Intimacy is judged on whether the person seems to care, and how secure we feel about trusting this person.

- Self-orientation refers to how much the individual is orientated to their own position. This may relate to how they charge (hourly rate or commission), or if they appear to care more about what they get out of the transaction.

Note that self-orientation is by far the most important factor. Someone who has a great deal of self-orientation is unlikely to be well trusted. 

How the formula works

Here’s an example. Imagine you’re buying a house and the ‘property consultant’ is pointing out all its  features and benefits. But do you trust her?

The consultant comes from a large firm and has been with them for 20 years. She clearly knows the local market and so has good credibility.

She has turned up on time and is well organised. She has brought along the LIM report, just as she promised. She scores well for reliability.

She remembers your names and that you have two young children, is friendly but not overly familiar, and you are comfortable with her. She has a good score on intimacy.

However, you know that the property has been on the market for a while and that the sole-agency period is running out. 

You also know that if you buy the property, the consultant stands to get a $20,000 commission. Her business model is self-orientated and so the amount you trust her falls accordingly.

When you consider an investment, take this formula into account, and if you’re at all concerned, do some more research before trusting someone with your money.

 

DEFINITIONS

Ponzi scheme: A fraudulent investment that relies on new investors to pay returns to older investors. When the new investors can’t supply enough money to pay the older ones, the scheme collapses.

David Ross: Kiwi David Ross ran New Zealand’s largest-ever Ponzi scheme, which left more than 700 investors owed about NZ$115 million. In 2013, Ross was sentenced in the Wellington District Court to 10 years and 10 months in jail after an investigation by the Serious Fraud Office and the Financial Markets Authority.

Bernie Madoff: American Bernie Madoff ran a Ponzi scheme that’s believed to be the largest financial fraud in US history. It is estimated 4,800 clients were defrauded of US$64.8 billion. Madoff was sentenced to 150 years in jail.