Common Marketing Ploys

…or how do some financial “advisers”
make themselves look better than they are!

There is strong and increasing competition among financial companies to get your business.

Some promotions are carefully tailored to hook the public. Here are a few of the common ploys.

A critical analysis would unmask these ploys:

Playing on people’s emotional response to risk

Making investment decisions should be a rational process. This requires determining not only the most-likely return, but also estimating the downside and upside returns; assigning probabilities to each case and thereby computing the investment Expected Monetary Value (EMV).

Using EMV as a yardstick permits a rational comparison of alternative strategies. Computing the opportunity cost of alternative investments should be mandatory.

A number of products are prescribed/sold by financial advisors and promoters that appeal to people’s emotions (greed and fear) and ignore EMV and opportunity cost.

One example of products that appeal to emotions are capital guaranteed investments. These products suit people whose main focus is avoiding the downside case.

However, a rational analysis may show capital guaranteed products have lower most-likely and upside case returns than equivalent products, invested in the same sectors, without a capital guarantee. The capital guaranteed product may forgo some returns by capping the upside and paying higher interest rates. Capital guaranteed products may have a lower EMV than equivalent non-protected products.

Beware any financial advisor and promoter that does not quantify the EMV difference between a capital guaranteed product and an equivalent non-guaranteed product. This EMV difference is the price an investor pays for security in protecting against the downside result. It may be a higher price than many realise! (There are no free lunches in the investment world…)

(A footnote: there are situations, however, where capital guaranteed products may have a legitimate use where the focus is not on getting a good return but solely on avoiding a bad return).

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Showing wealth projections in nominal returns instead of after-inflation returns

Often projections are shown in nominal (pre-inflation) returns - these overemphasize the result of implementing a proposed strategy.

The impact may be a lot less if presented in today’s dollars (“real” dollars or Net Present Value, NPV).

Here is a projection of the ASX All Ords Accumulation Index in nominal and real terms since 1980:

ASX All Ords Accumulation Index: Cumulative Returns pre and post inflation

Click here to see the real return after inflation. This puts the product performance in a proper perspective.

During the period 1980 – 2007, what was an impressive average compound return of 15.3% pa pre-inflation reduces to 9.3% pa when inflation is removed.

A 40% reduction in “wealth” would make a big difference in long-term projections!

Beware any long-term projection that does not show the real after inflation return (Net Present Value or NPV).

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Using unrealistically high returns

Further analyzing the above case, returns such as 15% pa are freely banded about when projecting future returns for the Australian sharemarket.

What is not apparent to most people is that sharemarket returns since 1980 have been unusually high compared to a longer perspective. During the 1960s – 1970s, average returns were less than 10% pa.

The Australian sharemarket average return of the last 25 years has been higher than the average over the last 100 years.

The main point is that future projections using the returns of last 25 years is very questionable and/or naïve. It demonstrates a lack of in-depth research.

(Note this discussion is not saying the Australian sharemarket is heavily over-valued at present – rather that recent past returns are not necessarily a guide to future returns. Haven’t we all heard that before, but how many people really do appreciate the significance of the statement?)

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Projections using gross return instead of net after-tax return

Many projections are shown using a gross (pre-tax) return.

What is questionable about this is returns should be apportioned between income component and capital component because these are taxed differently.

Consider a gross return of say 8% pa, of which half or 4% is income and 4% is capital return.

How much of the 8% does an investor get if they are on a particular marginal tax rate?

Impact of Tax on Income and Capital Returns

Considering the impact of taxation (one of life’s certainties!), the net return after tax ranges between 7.1% pa and 5.3% pa. This makes a big difference for long-term projections, compared with 8% pa.

Beware projections using pre-tax returns!

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Not benchmarking a review of past performances

Past performances of financial products may be shown, with seemingly impressive returns.

What the promoter may conveniently omit to show is median performance of peers during the same time.

The chart shows the cumulative performance of an Australian sharemarket product that had a superficially impressive total 160% return over 5 years.

What the promoter may omit to mention is that the median investor had a similar return! Click here to see median performance over the same time. This puts the product performance in a proper perspective.

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Not showing the opportunity cost of alternative strategies

Financial companies want the public to buy their products, so they show projections of the cumulative return of a proposed investment given certain assumptions.

Beware any projection that does not include the opportunity cost - the result if invest the same amount in another investment of similar, or different, financial risk.

At Archimedes Financial Planning, we compute the opportunity cost using the sophisticated techniques of the petroleum industry. This is a powerful evaluation tool that assists our clients to make fully informed decisions as to rewards and risks.

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