When it comes to investing, you need to know who and what you can trust. Trust your own judgment first, but know your limitations and of others you deal with.
Trust your own judgment foremost
Is it better to invest in a few things that you know well, or to diversify your risk?
Diversification has a long history. Fifteen hundred years ago, ancient wealth guru Rabbi Issac bar Aha said: 'One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.'
These days, investment professionals or fund managers use theory to create portfolios that minimise risk for a given level of return by carefully choosing the proportions of various assets.
Yet not all agree with this approach.
Economist John Maynard Keynes suggested: 'The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about... It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.'
Followers of Warren Buffett will recognise this stance; the famous industrialist used the same quote in his 1991 letter to Berkshire Hathaway shareholders.
Who is right: fund managers or Mr Buffett?
In practice, investors trust their own judgment more than they trust professionals. On average, investors hold a substantial amount in just a few assets rather than holding fully diversified portfolios, as suggested by conventional theory.
Recent academic research has shown that trust in an asset makes investors hold a disproportionately large amount. This is not a surprise: if you are knowledgeable about an attractive proposition, you are likely to be overweight in it. At the extreme, some investors hold only a tiny number of assets, and, on the face of it, are badly diversified. The new research suggests this is justified by the superior confidence in the investment.
One can see this in action in Singaporeans who invest only in property, a few well-known share counters and fixed deposits. These 'unsophisticated' investors may be savvier than they appear at first glance: they know and understand the local property and stock markets, and they trust Singapore banks not to lose their cash, even if the returns might be paltry.
Trust professionals a bit less
Of course, confidence cannot be misplaced - you need to know the limits of your expertise. And so, for most investors, the right strategy will be a blend of focus and diversification. This means a professionally managed investment has a place in many portfolios.
When one has no particular insightful understanding of a market it makes sense to buy into a diversified, broad market exposure: a good unit trust or an exchange-traded fund.
For example, you might believe you need exposure to Asian stocks but have neither the time nor expertise to identify which stocks to buy. In this situation you can trust that a manager cannot seriously go wrong with a basket of Asian shares in a well-regulated fund.
The limitations of professionals should be recognised. Good short- term performance can be due to luck. Even well-diversified portfolios cannot benefit fully from the unpredictability of future performance. Do not trust any adviser to pick the perfect portfolio (except in hindsight; the best you can hope for is a good portfolio). This is not a fault of advisers; it's just a reflection of the randomness of markets.
Place most trust in advisers who make recommendations that are clearly optimised for your interests (such as maintaining your portfolio risk at an agreed level), and not optimised for generating commission.
Trust complex products somewhat less still
As a rule of thumb, the simpler the product, the more likely it is to deliver what it promises. Structured products may be complex: they could embed derivatives, or be triggered by credit events or offer some form of capital guarantee. Typically, an investor has no deep knowledge of derivatives or financial engineering, and therefore has no real hope of assessing the risks or value of such products.
In the worst case, risks are not completely anticipated by the product manufacturer, let alone the investor or salespeople. Even in the best case, structured products may be pricey. For example, capital guarantees usually come at a cost (and besides, they could fail in a crisis, just when you need them). Such features may be motivated more by marketing departments than by investment considerations.
Capital guaranteed products need not be complex. A Singapore government bond (SGS) doesn't even charge you for safety (yes, the yields are modest). If you really need 100 per cent protection, you could invest some in SGS, and invest the balance in risky assets, such as shares.
If you come across a product that looks complicated to you, the rule should be: don't trust it.
Trust unlicensed salesmen least of all
Those selling unregulated investments such as wine, plots of foreign land, ostrich farms or such like, need to work very hard to gain your trust. This is partly because there are no third-party standards or verification by a regulator, and partly because unregulated products can suffer from lack of transparency. This doesn't mean all unregulated opportunities are sharp practice. Indeed, today's unregulated investments may become tomorrow's standard licensed fare.
However, you need to be wary. One warning signal is a selling point of phenomenal returns - an emotional appeal to your greed. That makes you vulnerable to a wrong decision. Likewise, a pitch of a 'smart' or 'exclusive' opportunity might be using your pride and gullibility as levers to open your wallet.
Spend some time on the Monetary Authority of Singapore website to see which firms are licensed and which firms are on the Investor Alert List. Although dealing with a licensed firm is not a warranty of a good investment, you can trust me when I say that an unlicensed scheme will not have a happy outcome if something goes wrong.
The writer is the chief executive of wealth management firm dollarDex.com
