Diana Clement: Kiwis need better understanding of risk

New Zealanders need to know what they're in for when making investments. Photo / Getty Images

Risk. It's a little word that causes Kiwis big problems.

That's because the average member of the public hasn't got a clue when it comes to weighing up investment risk.

Just this week I've been passed a letter from Christchurch-based Harmans Lawyers to its clients with the headline: "Investment Opportunity. Earn 8 to 15 per cent on loans secured by real estate".

I've come across this concept before. The word "risky" should jump out immediately when a person or organisation is seeking to raise money outside normal channels - and those channels would be a bank or mortgage lending company for property investment.

Although some members of the public will view lawyers as fully fledged members of the snake pit, others might see a letter from their nice be-suited lawyer and the words "secured by real estate" as being an endorsement and an indication that the investment was as safe as houses.

The individual lawyer promoting the deal knew the property trader well and considered it to be a good investment. But the letter gave no indication to his clients of the level of risk involved.

The offer was subsequently pulled, because Harmans "does not wish to get involved in giving any kind of advice about investments" and no one has invested. To their credit Harmans has also apologised and admitted it was an error of judgment made by one branch partner without wider knowledge of the other partners.

If this was Holland, says Ben Jacobsen, professor of economics and finance at Massey University, the lawyer would need to be registered to give financial advice and the product would have to have a risk rating on it - in the way that fridges here have energy rating labels.

Risk ratings aren't a perfect science. Jacobsen says in Holland, where he hails from, financial services providers know how to get around the rules and create products which on the surface have low risk ratings.

Even so, this would be better than what we have here. Without it, a very rough rule of thumb in the current market is that anything paying more than 10 per cent return is high risk, Jacobsen says.

Another of his rules of thumb is don't buy anything that has to be sold by cold call. If it was a good investment, it would have been snapped up by smart investors.

There is more to risk than the rate of return. I remember hearing that some finance companies were paying 10 to 12 per cent rates of return when the risk was more commensurate with 20 per cent. But no finance company would offer 20 per cent because it would make them look dodgy.

Investors need to acquaint themselves with the concepts of both market risks and individual investment risks, says University of Auckland's professor of finance David Mayes.

An example of this might be that residential property investment has both market risks and individual property risks. Likewise, residential property is safer than investment property because if your world turns to custard, you can still live in an owner-occupied home and you'll get an easier ride from your lender.

Another individual property risk may be buying a problem property as an investment, thinking you can sort the problem - such as an illegal sleepout - and sell it on at a profit.

In this instance the added risk would be that you find the flat can't be legalised or it takes far longer than expected and your holding costs are too high.

There is also catastrophic risk, which people simply blot from their minds. In the case of property this may be having the lender call in the loan through no fault of your own and you can't refinance. The words "house of cards" come to mind.

If you're the investor who has lent money to a property trader, you're at arm's length and can't do anything to control or minimise this risk. Even a finance company would have spread your investment over a basket of risky mortgages, not just one.

The Harmans letter has got financial advisers' heckles up for different reasons than my concerns about risk. Advisers are set to come under regulation from July 1, 2011.

They will have to provide disclosure statements and belong to a dispute resolution service. They argue that lawyers and others that can sell investments, such as property marketing companies, should come under the same rules.

They're right, although as Mayes points out, a member of the public is unlikely to be able to tell a good disclosure document from an indifferent one.

Another issue is that sales techniques that are banned in other countries are acceptable here. "I am honestly flabbergasted at what is allowed here," says Jacobsen.

"New Zealand is the Wild West. Regulation here is light, to put it mildly, and there seems to be no enforcement of the rules (especially by the Securities Commission). That would be unthinkable in Holland or any other civilised country."

In Holland and the UK, for example, it's not legal for anyone to phone individuals from overseas and sell products. Yet here I get cold called from the Gold Coast with some regularity.

Mayes adds that other developed nations typically have regulatory regimes that make it a lot more difficult for risky products to be sold to individuals.

New Zealanders are no less financially literate than consumers in other developed countries, he adds. But they need a higher level of financial literacy because we have relatively light-handed financial sector regulation.

The problem is that people have to want to be educated, whereas most don't seem to even know they need to get in the starting blocks.

Given that most people can't accurately compare risk between financial products, they must rely on others to form a judgment, says Mayes. This may involve employing a financial adviser, or considering ratings from international agencies such as Standard & Poor's and Moody's before investing.

Even ratings agencies don't practise a perfect science, says Mayes. These agencies have made mistakes and some experts are dubious about the way they are paid.

In the case of financial advisers, more than would admit it have either not understood the risks of some of the products they sell, understood them but played them down, or simply ignored risks in order to gain commissions.

The most public example of this was on the Herald front page again on Wednesday: The ANZ bank's selling of two ING funds to ordinary investors. Many of the investors were led to believe they were buying low-risk products on a par with bank deposits, whereas the funds were investing indirectly in the more risky end of the US residential property market.

Mayes can see a reason for investors to use advisers working for banks.

Even with regulation you have more protection if that adviser is a bank employee because if need be, you can complain to the Banking Ombudsman as well as the other usual channels for complaints about financial advisers.

The ANZ's clients will eventually receive more of their money back than others who invested through other independent advisers. Similarly, in the case of rogue ASB adviser Stephen Versalko, the bank ensured its clients didn't lose a cent.

A final thought. You'd think that Kiwis would understand risk better after the last few years when tales of woe abounded and would never invest in another finance company or packaged property investment of the type offered by Blue Chip and a number of lookalike companies.

I hazarded a guess this week that members of the public would be back investing in the next generation of these investments within 10 years. Mayes pooh-poohed my idea. Memories weren't that long, he said, and suggested five years was a more realistic time-frame.