Monday, July 12, 2010

Can You Trust Your Financial Planner?

Below is the first article that I contributed to CPF's IM$avvy. It discusses the current state of the financial planning industry in Singapore. I hope readers find this useful.

Being too trusting of others can sometimes work against us in financial planning. Too often, we are not skeptical enough when it comes to financial advice offered by others. Can you trust your financial planner? Is he really providing independent and unbiased advice or is he just trying to close a sale?

Advisory Business or Sales Business?

When the Financial Advisers Act was first introduced in Singapore, many thought that the financial planning industry would come up with a new breed of financial advisors who were independent and unbiased. While the fee based or fee-only model of financial advice is slowly taking off, most people in Singapore are still unwilling to pay a financial planner for the time and energy he takes to craft a financial plan. As long as the market is not ready, financial planners will continue to be compensated based on commissions.

A thin line separates the financial advisory business and the sales business. A sales person is one who derives his income from commissions. On the other hand, the financial advisory business is supposed to provide independent and unbiased advice to clients. It is important to realize that potential conflict of interests arise when financial planners earn commissions from the sale of financial products.

If your financial planner is earning a commission from you, can you trust that he will make the best financial decision for you? If a financial planner is selling you a product that you know very little about, how can you trust that the product is suitable for you?

Financial Products and Imperfect Information

I just read a book and it talked about a wallet auction.

Imagine that I pull out my wallet from my pocket and placed it on the desk in front of me. How much will you offer for the money in it? Whatever the case, any buyer of my wallet will be certainly worse off as I will only accept offers that they should not be making. I know what I am selling but the buyer does not know exactly what he or she is buying. It all boils down to information asymmetry or imperfect information.

The same theory applies to financial products. Imperfect information exists and the buyer has to overcome his lack of knowledge of the situation or of the seller. Market economies often deal with this problem through the mechanisms of advertising and reputation. As a consumer of financial products, your perception of a certain company’s reputation might influence you to purchase the product or invest in certain instruments. Or perhaps you have seen some advertisements that offer yields and gains that are too tempting to resist. Or perhaps, your friend had recommended a “reputable” financial planner that you can trust.

The reason why buyers rely on reputation and advertising is that they are not willing to spend the time to overcome the information asymmetry that exists. For example, a doctor gives me a prescription for a certain ailment. I trust his recommendation because of his reputation and credentials even though I am clueless about the medication that he has just offered me. In this case, it is unwise of me to spend 5-6 years of my time going to medical school just to breach the information asymmetry that exists between him and me.

But are financial products so complicated that we cannot take some of our own time and effort to breach this information asymmetry? Can you still trust that your financial planners will give you the best recommendations when there is a potential conflict of interests?

Trust Yourself: Financial Education

One simple way to overcome this information asymmetry would be for the consumer to become educated in financial matters such that they are better able to understand their own financial situation and make better financial decisions. This would help them better understand the financial products that they wish to purchase. For the beginner, the CPF IMSavvy website has a comprehensive list of articles that should serve as a good foundation for anyone interested in becoming more financially literate.

Are you willing to invest the time and energy to learn more about financial planning? Or do you still trust that a financial planner will do the best job for you?

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