A Quick Way to Examine an Investment Product
In my work, I am frequently being asked to advice on investment products. Especially those which promise “high returns and low risk”. I must admit that some of the marketing effort of such products were very well done and persuasive. However, most of them were sugar coated poisons. There is no such thing as “high returns with low risk” investment products. Let me share with you a quick way to examine an investment product. This method is to know the prime lending rates of major banks in each country.
Prime rates are the lending rate which a bank would lend to its best 10% customers. In Singapore, the prime rate is around 5.3%, in the US the rate is around 8.3%. This is the rate which drive business activities, because most businesses (in any economy) use debt to finance their working capital or build resources. Most of the time, not many people will qualify for prime rate, and usually we are charged a few percentage points over the prime rate (e.g. 2% + prime rate).
I am always amused when “professionals” try to convince me of a seemingly guaranteed investment products of 20%-25% per year (I have even seen a “40% p.a.” return product promotion). If this will be the case, this product will create an “arbitrage” situation in the financial market of a country, where people can borrow from the bank and “invest” it into the product and profit from the interest differential. Let's assume a business can borrow $1M at prime rate (5.3%), and then invest at “20%” guarantee. The borrowing interest cost would be $53K, but the return profit would be $200K. Therefore, there would be a gain of $147K, without doing anything! In no time, such economy will collapse. This was the scenario in Indonesia and Thailand in 1997, and subsequently, both of these countries were hard hit by the financial crisis.
This is the reason why a government's bond coupon rate is always slightly lower than the prime rate. Equity will generate higher return than the prime rate, but the trade off will be its uncertainty. Therefore, if the product advisers still insist they are right, you can be sure that there will be some risk which is not explained.
The only “high return & low risk” financial product is the Ang Boa (red packet) from one's grandparents during festive occasions.
God bless you.
Prime rates are the lending rate which a bank would lend to its best 10% customers. In Singapore, the prime rate is around 5.3%, in the US the rate is around 8.3%. This is the rate which drive business activities, because most businesses (in any economy) use debt to finance their working capital or build resources. Most of the time, not many people will qualify for prime rate, and usually we are charged a few percentage points over the prime rate (e.g. 2% + prime rate).
I am always amused when “professionals” try to convince me of a seemingly guaranteed investment products of 20%-25% per year (I have even seen a “40% p.a.” return product promotion). If this will be the case, this product will create an “arbitrage” situation in the financial market of a country, where people can borrow from the bank and “invest” it into the product and profit from the interest differential. Let's assume a business can borrow $1M at prime rate (5.3%), and then invest at “20%” guarantee. The borrowing interest cost would be $53K, but the return profit would be $200K. Therefore, there would be a gain of $147K, without doing anything! In no time, such economy will collapse. This was the scenario in Indonesia and Thailand in 1997, and subsequently, both of these countries were hard hit by the financial crisis.
This is the reason why a government's bond coupon rate is always slightly lower than the prime rate. Equity will generate higher return than the prime rate, but the trade off will be its uncertainty. Therefore, if the product advisers still insist they are right, you can be sure that there will be some risk which is not explained.
The only “high return & low risk” financial product is the Ang Boa (red packet) from one's grandparents during festive occasions.
God bless you.
posted by Allen Lim @ 12:36 AM
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