The Most Dangerous Word in Finance

What’s the word investors love to hear more than any other? It’s “safe”. Safe is soothing, it implies someone’s looking out for you. That someone cares about your hard-earned money, as if they were there to see the sweat dripping off your brow while you earned every cent of it. They understand what it means to you. Safe suggests your wealth is to be guarded, by steel, concrete, locks, security, and abnormally large men holding threatening weapons.

These are all assumptions. Hearing the word safe is an opportunity to assume much more on the sunny side about an investment and the people behind it, than seeing any dark clouds. For some investors “safe” is a face value signal there are no concerns. They can have full faith and set aside the need to better understand the details.

Unfortunately, an unwavering belief in the word safe has cost investors a lot of money over the years. The word “safe” has catapulted billions of dollars from boring (and actually safe) bank accounts into other investment vehicles tagged with the word “safe”. Those dollars are chasing anything from a slightly better return to a significantly better return.

Which tells you everything you need to know about what safe means to many investors. Safe’s not just about safe. It’s also about return. The following equation spells it out:

Return – Risk = Safe

It’s a return with assurance that that these investors want. A better return without any potential downside, but the above equation is a lie. There has never been any asset that gets safer as the potential return increases.

What is safe? Deep down everyone knows the bank and whatever it offers is safe. It comes with a government guarantee, and you know it will be there come withdrawal time. This is what safe is. It’s not about return. Safe means you’re prepared to overlook growth to ensure the certainty of your short-term spending, while ignoring any bites of tax and inflation. Nothing else.

We bring this up, because as we’ve often said, low interest rates prompt scams. Investors who say they want “safe” will also hunt higher returns. Record low interest rates had people dry retching when they saw the bank was offering 0.5% or less. That starts a hunt for something better. Of course, that something better also must be “safe”. Scammers understand this dynamic.

There were warnings last year that fake bond fund prospectuses were circulating. Many big financial names were seeing fraudulent offerings in their names. Vanguard, Pimco, HSBC, IFM, Citibank, Nomura. Some of the returns being quoted ranged from credible, around 2%, to ridiculous, over 9%, but a fixed return is just another red flag.

More recently, scam comparison websites were set up to solicit for fraudulent bond offerings. Everything checks out and appears legitimate, until the investor has handed over their money. Unfortunately, several people handed over significant sums of money.

It’s uncanny how well targeted and timed these scams are. Historically bonds haven’t been as volatile as stocks, but they have usually offered a better return than the bank. Many investors don’t necessarily understand bonds beyond this dynamic. Scammers know they’re not going to get traction with cautious or inexperienced investors by setting up a fake stock fund. Everyone understands stocks are volatile, but bonds are “safe”, right?

This is a two-part problem. First the scam, which is very in depth. Cloned websites, comparison options and copied prospectuses. It looks and feels real. In some instances, there might be a detail missing, but when investors say they’ve “done their research” on these details they probably have. All the names and company numbers checkout because the scammers have used real details, except for the contact details. When phone calls are made, assurances are given. All the logistics and details appear correct.

The second part is the investment in bonds. The news stories repeatedly reference these investors as being “financially savvy”. In one case, it was a maths teacher who’d heard from a friend that government bonds were a safe investment. In another, it was an accountant who was looking to put his money somewhere short term and was embarrassed because he worked in finance.

Savvy? Not for us to judge, but it’s unlikely they understand bonds, the financial environment we’ve been in or did any research on the asset class.

In normal times high rated bonds are generally considered safe, at least safer than stocks, but less safe than cash. In a portfolio they play a valuable role as a buffer and diversifier to stocks. When stocks sell off, bonds go up in value. There’s also an income payment. It can be higher or lower depending on the risk of the entity offering the bond. That’s in normal times.

Lately hasn’t been normal times. Interest rates hit record lows and with inflation increasing this year, interest rates had to increase. This meant bond prices would be going down. If someone was already invested as part of their portfolio or continuing to contribute for the long term and they were happy to take the distribution, then this likely wasn’t an issue. Rates will normalise and bonds will go back to playing that safer role to stocks, with higher distributions.

This is very different to a new investor dumping all their money into bonds as a short-term “safe haven” while chasing a better return than the bank. An investor doing this likely had zero understanding of their action. As soon as rates increased, they would see a decline in the value of their asset. Had their investment been legitimate, odds are they would be irate about the decline in value of their “safe” investment.

One of the positives to come from the legacy of financial scams is investors are now more alert. They are conditioned to look for credentials and registrations to ensure they’re dealing with legitimate entities. The negative? Scammers understand this and don’t play by any rules. They will use the details of legitimate entities as cover.

Investors can double check an ABN or an AFSL to make themselves feel better before ploughing ahead into a fraud. It’s very hard to address this problem when scammers are continually a step ahead.

It’s also a false sense of security. Investors can double check an ABN or an AFSL to make themselves feel better before ploughing ahead into a legitimate investment they don’t understand. For all the researching details, credentials, and registrations, the average investor is still not sophisticated or well researched enough to identify risks or understand how financial markets work.

Putting faith in the word “safe” is no substitute for understanding the basics.

This represents general information only. Before making any financial or investment decisions, we recommend you consult a financial planner to take into account your personal investment objectives, financial situation and individual needs.

With thanks to FYG Planners for this article