Last week I wrote about the evils of inflation. I wrote about how surprised I was that many people I encounter continue to leave large sums on deposit, often while living frugally, despite knowing that inflation is eating away at their wealth.  

I gave two recommended courses of action: spend and invest. It seems so obvious, right? Then why do I see so many clients sitting in front of me in this boat?

Reluctance to spend I don’t get. I’m perfectly happy to spend on myself (within reason) but I know that a lot of people find it counter-intuitive, especially if they’ve spent their lives making sure everyone else was well looked after. But I can absolutely see how investing could seem daunting.

I read two very different – both excellent – articles this week from respected people in financial services. Both, in their own ways, shed light on why people who love the security of having cash in the bank avoid investing.

Blinded by past returns

Gary Connolly writes in the Sunday Times that the low- or negative-interest environment in which we live may cause investors to cast aside some of their usual caution in the search for a return. He worries that risks are being overlooked or misjudged on the basis that recent history, or back-testing as it’s called, showed high returns.

Just because something inherently risky has worked well for years doesn’t mean it always will. He gives the analogy of Siegfried and Roy, a duo of magicians who made lions and tigers disappear. The show ran for 13 years until, one day, Roy, one of the tamers, was mauled by one of his feline charges.

An investment proposition will always carry risk, but when it performs well, investors (new and existing) are inclined to ignore the risk, blinded by the returns, he says.

Look the gift horse in the mouth

Colm Fagan’s blog Diary of a Private Investor documents his experiences as investment manager of his own pension fund and the manager of a separate investment portfolio.

He told of a too-good-to-be-true investment opportunity that a friend introduced him to. This was a 5-year lump sum investment, linked to a stock market index. At the end of the term, if the index was at or above its starting point, the investor would make 40%. If, on the other hand, the index was below the starting point, he or she would lose 15% at most. This product was backed by one of the world’s top investment banks.

Colm did some research. The index to which the investment was linked was an obscure one created it would seem for the investment bank. Its make up was very odd. Colm discovered that half the stocks included in the index were chosen specifically to devalue the index.

But the marketing material says…

The brochure for the product showed that over the last 14 years, this strange index had outperformed EURO STOXX 50, the standard benchmark index for Eurozone stocks, but the indices bore no resemblance to each other. It was like comparing apples and oranges, lion-tamers and financial advisers… though some might say they’re broadly similar. It looked like the index had been chosen simply because it outperformed the EURO STOXX 50 in this period.

Having done some further work, Colm concluded that there was a one in six chance of earning 140% from the investment (the same as rolling a six with one die) but a five in six chance of losing money.

Stories like this turn my clients with excess cash in the bank right off investing but there are people out there, hungry for a return, who will go for it, ignoring all the risks because in 13 years Roy’s white tiger hadn’t bit him.

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