Financial Toxic: Bond Funds

This is the third installment of my financial toxic series. In this article, I am going to look at something that most people like financial professionals consider as “safe”, bond funds. Bonds are considered safe because the financial textbooks say so but I am going to show you the opposite.

Before I move on, let me repeat my disclaimer. This article is an expression of my personal opinion. I am neither a licensed financial adviser nor a financial expert. I am only an engineer. Here is the difference: Financial advisers and financial experts are trained to obey everything written in their text books without question while engineers are trained to think and analyze logically.

Next, I shall set the definition on the topic itself. There are basically 2 types of bonds based on the credit ratings of the institutions that issue them. Investment grade bonds and junk bonds. In this article I shall focus entirely on the investment grade bonds. These are the textbook case of “safe” investments but in reality they are toxic and I will show you why.

There are basically 2 types of poison. Poisons can either kill you immediately or kill you slowly over a long period of time. Financial toxic can work in both ways as well. In my previous installment, I have explored on whole life insurance plan. Whole life insurance is an example of slow acting poison. You will not be bankrupt immediately after you bought it but in long term it sucks your money away which you could have put to use to grow at a much better rates. Your finances will die a slow death because of it. Bond funds work in the same way. It will kill your finances slowly but surely.

I shall address the characteristics of this toxic now.

Effects of inflation.
I suspect many people may ask on how can such a safe investment be toxic? Let me give you a magic word to explain it all – inflation. The higher grade the bonds are, the lower will be their coupon yield. So, if you opt for only the highest graded bonds, you will get the lowest interest. The interest will be lower than the rate of inflation. Even if the underlying bond issuers never go bankrupt you will still be poorer in terms of purchasing power.

Investing in bonds for long term is like buying a huge block of ice, put in under the cover of an umbrella under the tropical sun. The ice will not vanish in split second but you can be sure that it will only continue to melt. In long term, the ice will cease to exist. This is the same for bond funds. Inflation will eat away your assets. You may have more money but the amount of things you can buy with them will be lesser. This investment will only make you poorer.

So, if there are financial advisers trying to promote bond funds to you, ask them about the effects of inflation.

Some people may ask, “How about short term?” The answer is below.

Sales and management charges.
All mutual funds come with sales charges. Whether they are “front-loaded” or “backend-loaded”, they are still sales charges. This is the way financial advisers and insurance agents make money doing your “financial planning”. This is also a good opportunity for those who are good in sales to make a lot of money.

The existence of sales charge means you can never hold your mutual funds for short term. Let me give you a numerical example. Suppose the sales charge is 5% of the investment amount and you have invested $10,000. Out of the $10,000, $500 will go to the financial adviser as commission for his or her effort in getting you to part with your money. So your actual investment is $9,500. In order to break even in a year, your $9,500 investment must grow by 5.26% in that year.

Think. How likely is it for a low yielding bond fund to generate 5.26% in a year? In reality, the first few years of your investment is to make the money for your financial adviser. Therefore we rule out investing in bond funds for short term.

Capital appreciation.
Apart from coupon yield, bond prices can also enjoy capital appreciation. Bond prices are very sensitive to the prevailing interest rates. They move in opposite directions. When the interest rates go up, bond prices go down. When the interest rates go down, bond prices go up. It is a good idea to buy bonds if the interest rates are about to go down and sell bonds if the interest rates are about to up.

I have attended several sales talks for bond funds. In all the talks I have notice a common thing. All the presentations had various charts to show that the interest rates are always going down. Why? They are just doing their jobs in making you part with your money. By the way, they are not completely wrong. If you always tell people that the interest rates are going down the probability of you being right is 50%. You are right 50% of the time.

I challenge you to test out this theory of mine. Find any investment talk or seminar on bond funds and attend some of them. I can guarantee you that you will always see “proofs” on the interest rates going down. Don’t be too hard on them. They are just trying to make a sale.

Having said all these, I am not ruling out that bonds can appreciate in value but that does not mean the investor can benefit from them. The only way you can benefit from the appreciation of bond prices is for you to sell the bonds immediately after they have appreciated in value. If you leave them in your bond fund for long term, the value will drop again when the interest rates go up.

The appreciation of bonds prices is only beneficial for bond traders, not for investors of bond funds.

I have put up the above 3 points to show you the reality of bond funds. I hope you will realize by now that bond fund is a slow acting poison. It may benefit the person to sells it to you but it can only make you poorer. I doubt you can find this truth in any of the financial text books.

The rest is up to you. Who will you choose to trust, an engineer or a financial expert?

Financial Toxic: Whole Life Insurance Plans

This is the second installment on my financial toxic series. In this article I shall explore a common insurance product known as whole life insurance plan. It is also known as whole of life in some countries. Basically, it is meant to last as long as the life of the underlying person insured under it. I am sure many people have such plans in their portfolios and it has generated a lot of commission income for those who sold it. However, the product itself is toxic and I am going to prove it.

Before I move on to the proofs, let me repeat my disclaimer. This article is an expression of my personal opinion. I am neither a licensed financial adviser nor a financial expert. I am only an engineer. Here is the difference: Financial advisers and financial experts are trained to obey everything written in their text books without question while engineers are trained to think and analyze logically. In addition, engineers do not receive commissions for selling financial toxic.

Now that I have presented my disclaimer, I shall proceed with my points. Let me start by presenting the sales pitch for this product.

Sales pitch.
This is a savings plan. You save some money regularly in this plan. If you die, the insurance company will give a huge sum of money to your family. However, if you live to old age and do not need insurance protection anymore, you can take out the money you have saved. You will get back all the money you have put it plus interest which will definitely be more than what the banks can give. So, you have everything to gain and nothing to lose in this plan.

The hidden truth.
As you can see, the above is the common sales pitch for this product. Is it true? The answer is, it is only partial truth. There are other facts that are intentionally hidden in order not to lose the sale. Let me present the hidden truths in this product.

I shall address the insurance portion in the later part of this article. Here I will show you the flaws in the “savings plan” pitch. It is true that you keep the whole life plan for a long time like 20 years before surrendering it, you can get back more than you have put it only if you do not factor in the inflation rate for the whole of 20 years. If you factor in the rate of inflation, your real gain in this “savings plan” will be very small if not negative. So, it is a bad savings plan.

The sales pitch also compares this product with bank deposit. I find this comparison to be totally idiotic. Maybe, those sales folks really think the public as idiots to come up with such comparison. Let me show you why this comparison is flawed. Our money in the banks is liquid. We can withdraw them anytime we want. Even if you have put your money in a fixed deposit, you can still take the out at some cost like forfeiting the interest or even some penalty fees. You can never do that in a whole life plan.

If you have just bought this plan, there is no money in your account even after you have paid a few installments. Why? Most of the money you paid goes to the commission income of your agent, your agent’s manager and the agent’s manager’s manager. (In Singapore, the government allows up 3 levels for commissions.) The rest goes to the insurance company to cover the cost of administration and risk. So, you have nothing. Does this sound like day light robbery to you? This tells us that it is possible to rob legally. All you need is to sell this plan.

After some time, when the agent stop taking your money, you will have some cash value in your account. However you can never take them out without giving up this plan. The insurance company in its mercy will lend you the money you want based on the cash value in your whole life plan with interest. In other words, the insurance company will lend you your own money and charge you interest for it.

Next, let us look at the opportunity cost of this plan. If you have put in the same amount of money in an index fund that tracks index like S&P500 for 20 years, you will surely have much higher profits with close to zero probability of loss.

Are you convinced by now that the insurance companies have a very low opinion of your intelligence?

Therefore, the slogan that says the whole live plan is a savings plan is nothing more than an insult to our intelligence.

Next I am going to present what the whole life plan truly is.

Components of the whole life insurance plan.
The whole life insurance plan is made up with the following components:
1. High cost insurance.
2. Low yield investment.
3. High commission.

This first and second component makes it toxic but the third makes it the bestseller for insurance companies. Welcome to the world of financial services. You can sell any toxic waste as long as you are willing to be generous with the commissions. There will be a lot of people are willing to suspend their moral integrity to help you to sell your toxic. Of course the buyers of this toxic will the ones who will suffer the consequences but who cares. The commissions are in the accounts of the agents when it happens.

I am sure many people, especially those who make money from selling this plan will challenge me on the first two points. I shall explain in detail on them.

High cost insurance.
In order to help you to understand this part, I shall explain the basic operation of an insurance company. This may sound surprising to you but the truth is, insurance companies operate on the same principle as casinos and gaming companies. It is based on the law of probability.

If you go into a casino and place your chips in one of the squares on the table, you may win or lose but the casino always wins at the end of the day. In every hour, the casino collects a lot of money from those who lost their bets and gives away a lot of money to those who won. However, at the end of each day, it can be very sure that the amount of money it collects will be more than the money it gives away. Why? The rules of the games are designed this way. The house always has the edge.

Insurance companies work the same way. Every month, they collect a lot of money in insurance premiums. At the same time, they also give away a lot of money as insurance pay-outs, commissions and other costs. However, they can be very sure that in every year, the amount they receive is more than the amount they give out. They set their rules like the premium rates to ensure this.

This is why insurance companies operate the same way as casinos. The difference is, casinos do not insult our intelligence by telling us that they have savings plan for us, they care for our financial future or they care for our families.

How does this relate to my allegation of high cost insurance? Suppose that you are young and healthy. You want to buy a one year term insurance. How much do you think the insurance company will charge you in relation to the payout you expect? The answer is it will try to charge you a low as it can. Why? There is close to 100% certainty that you will stay alive for the coming one year period. The company can collect your premium and expect not to pay you anything. You are an ideal client. The company will try to charge as low as possible in order not to lose your business to its rivals.

This is like lottery. You pay a small amount of money for a small chance of winning a lot of money. In the above insurance example, you pay a small of money for your family to have a chance of receiving a lot of money if you die within the one year period. However, there is a huge chance that you will not die.

How does this affect the whole life insurance plan? In this plan, as long as you hold on to it, you can be certain that you will be eligible to receive the payout. In other words, you can be sure of hitting the jackpot. You only don’t know when. Let us use some common sense here. Do you think in the insurance company will lose money selling your this plan? Do you think insurance companies will design products that will make their customers make profit at their expense? I believe the answer is quite clear. The premiums must have been set in such a way that they will be more than the payout you are expected to receive after taking into account their time value.

Buying a whole life insurance plan for protection is like buying all the lottery tickets for one draw. If you buy up all the lottery tickets in one draw, I can give you 2 guarantees. The first guarantee is you will qualify to win all the prizes offered. The second is, the total amount of money you spent in buying all these tickets will be more than the total amount of prizes you receive. So, you will have a net loss. In other words, a certainty of loss.

The only way you can “win” in a whole life insurance plan is when you die early. If you happen to live to ripe old age, your situation is like buying all the lottery tickets. So, do you still think this product is a good deal? Welcome to the high cost insurance.

Low yield investment.
Now, I shall explain why the investment returns for the whole life are always so low even when the stock market is booming. If you have such plans, you will notice that the cash you have inside it will always go up and never comes down no matter how bad the stock market is. This is an example on how the system works.

Suppose the market is booming and the insurance company makes 20% from its investment return in a year. It will not give you the full 20%. It will credit only 3% into your account leaving the balance of 17% in reserve. In a bad year where the investment suffers a loss of 5%, it will take out the reserves, make up the loss and still give you an annual return of 3%. So, you will have the impression of a consistent gain but do not be fooled. It comes from your own money. As I have mentioned earlier, if you have placed the same amount of money in an index tracking fund for the same period of time like 20 years, you can get in excess of more than 10% annualized returns safely. This is certainly more than the mere 3% annual returns from the whole life plan.

(The 3% I used is meant to the overall investment returns including the generous commissions paid to the agents. Without the commissions, the investment return in your insurance plan will be much higher.)

This explains why the investment portion in the whole life insurance plan is consistently low.

I hope I have explained sufficiently on why the above product is toxic. The money spent on this product can be allocated somewhere for better returns. Please note that I have never said insurance is bad. All I said is some insurance products are simply toxic and should be avoided. Otherwise you will only be making others rich at your own expense.

Financial Toxic: Structured Products

I am starting a series in financial toxic. In this article, I shall focus on the analysis of structured products sold by financial institutions. Before I move on, I would like to state my disclaimer. The entire article is written based on my personal opinion. I am not a licensed financial adviser nor am I a financial expert. I am only an engineer. Financial advisers and experts are trained to obey everything written in the financial textbooks while engineers are trained to think and analyze logically. This explains why engineers have different views from financial advisers and experts.

Let us begin by some basic introduction on the subject under discussion. What are structured products? To put it simply, they are things that you pay a certain amount of money for. When certain conditions in the contract happens you will receive a certain amount of profits but when another set of conditions happen, you will suffer loss. This is supposed to be an “investment”. How do they work? I don’t think any one other than their creators know. This means not even the sales people (also known as relationship managers) know anything about them other than their commission and sales quota. They are extremely complex.

This is another proof on how bad it is when non-engineers are in charge of the financial sector. Why do you think they create such complicated products? Are complications necessary for our investment needs? I don’t think so. It is clear that such complications are only meant to mislead and deceive.

Engineers do encounter complex problems in our work. However, our role is to simply them. Let me share some of my experience in this regard. Once I was working in the construction of a recreation club at a hill slope. The whole plan is very complex. Due to many changes in the design, the drawings do not match anymore. The architectural and structural drawings were no longer showing the same thing. Nobody knew what to do.

When I first got in, my role was to set things in order. I knew that there was no use writing to the consultants to ask them what to do. I will only get some general answers, which will require me to ask even more questions. The only solution I could see was for me to take out the relevant drawings, take out my stationary and draw out the details that matches the engineer’s and architect’s requirements. Then I faxed my drawings to the consultants to ask for approval. They only have to answer “yes” or “no” and I always get “yes” to all my drawings. After I got the approval, I made photocopies of my drawings and pass them to the foremen to built accordingly. Most of the development was built based on the diagrams I drew. Basically, I had simplified a complex development into simple diagrams that individual workers can build.

This is what engineering is all about. The existence of the structured products shows us that their producers are doing the opposite from the principle of engineering. While we simplify complex stuff, they complicate simple stuff. The question here is why do they do that?

All products are supposed to meet the demand for specific needs. For example, our need to protect our feet creates the demand for shoes. Our need to protect our heads creates the demand for hats and helmets. So, what needs do the structured products fill? The answer is none. The structured products do not fill any need and there is absolutely no demand for them. However, they still got sold.

How did they do it? The answer is in the generous commissions and high pressure selling in a morally challenged environment. Let me explain in the Singapore context. In Singapore, we have a lot of senior citizens who have accumulated a lot of savings in the bank due to their thrifty lifestyles. They do not have much education and do not know much English. So, the only investment they know is fixed deposits.

When these people go to the banks to renew their deposits, the banks’ tellers referred them to the relationship managers who then introduced them to invest in the structured products sold by the banks. These relationship managers managed to convince their prospective clients (or victims) that the investment is as safe as bank deposits but produce a much higher interest. They made a lot of sales. When Lehman Brothers collapsed, the rest is history. Many senior citizens found themselves losing their life savings in their “safe” investments.

Even professionals who can read in English bought those products. Obviously they trusted those relationship managers more than they trusted in their ability to read in English. Somehow, these professionals must have thought that the title “manager” makes a person honest. Now they had to pay for their mistakes with their life savings.

This may be an isolated event but it tells us very clearly that the structural products are designed to make us part with our money. This is their only purpose. Their complexity is meant as a cover. Therefore the only conclusion here is never buy any of them. Shun them like toxic waste.

Of course, I will not be surprise if there are investment experts like financial advisers and relationship managers who disagree with me. After all, who am I to prevent them from earning their commissions?