How

(September 2007) At the beginning of the summer of 2007, a new language seemed to emerge. The media, pundits, advisors, doomsayers were all talking in what I called the “alphabet acronyms” — i.e., CDOs, ABSs, ABCP and so on. I would wager few financial advisors gave much thought to these products before they became the talk of the town. While the jury is still out on the ultimate effects of these products, they did help us remember some key points about the markets and investing.

The credit-market turmoil in the late summer changed all that. CDOs (collateralized debt obligations) and ABCP (asset-backed commercial paper) became headline financial news. Increasing defaults by sub-prime mortgage borrowers and the lack of transparency as to how much of these were in certain asset-backed securities (ABSs) led to a brief period when markets were unable to value ABSs. Liquidity in these markets dried up and threatened to spread to many other credit and financial markets around the world. Markets that lack liquidity can’t function, and that raised the spectre of credit drying up around the globe. That threatened the real economy — the production and consumption of goods and services.

Central banks moved into high gear, providing large injections of liquidity to financial markets, while private financial institutions also banded together to help restore stability. As this article is being written, markets have (somewhat) calmed down, though the coast appears far from clear. There is still uncertainty in credit markets and while the fundamentals of most economies remain good, there is no certainty as to economic health in the near term. Despite the remaining uncertainty, we can glean some useful lessons from the summer of 2007.

The lessons from the credit-market turmoil aren’t new, but they need to be relearned.

Complicated isn’t always better

Innovations in financial markets and in investment vehicles have contributed hugely to the financial services business. Innovation works only when it doesn’t try to defy the laws of financial gravity. The sub-prime mortgages that fail to impose any reasonable credit standards on the borrower are not credit instruments. They are essentially a bet that housing prices will always rise. As we have been reminded by the performance of the U.S. housing market in recent months, they don’t. Investment vehicles that don’t allow the holder to know what is behind them prevents the investor from making any sort of rational judgment as to whether they have an appropriate risk/reward profile. None of this is an argument against the increased sophistication of financial markets. It is an argument that what you don’t know about an investment can hurt you, and complicated is not always better.

There is no free lunch when looking for yield

The rush into asset-backed securities can be largely explained by the relatively attractive yield these instruments offered. In retrospect, the yield wasn’t high enough to properly reflect the risk. The search for yield in a low interest rate environment is not new. We have been there before with income trusts. Interest rates have seemed extraordinarily low in recent years, especially on longer-term government bonds. Until yields move up significantly — if they do — advisors and clients are going to have to learn to deal with low rates. The implication for advisors is that an asset allocation appropriate to each investor is crucial.

Risks in financial markets must be priced appropriately

When higher risk doesn’t offer a higher reward for an investor — and vice versa — there had better be a really good explanation. Although there have been several explanations put forth as to why investors accepted the mispricing of risk, none of them change the basic issue that higher return means higher risk. The good news is that it is likely that risk in financial markets will be more properly priced going forward. The lesson from the summer of 2007 is that just because a market anomaly can’t be explained doesn’t mean it should be ignored. I have long been convinced that many investors don’t understand what risk is. This represents a huge challenge to financial advisors.

There are no shortcuts to saving and investing for retirement

There are two parts to saving and investing for retirement. They are saving and investing. No investment strategy is likely to compensate for a client who is simply not saving enough in the first place. And the best saver in the world needs good thoughtful advice, as well as patience and discipline, to achieve his or her investment goals.

Know your clients’ assets as well as you know your clients

“Know your client rules” have been with us for a long time. They are the cornerstone of providing good advice to clients. The lesson from the recent credit market is that advisors must know and understand their clients’ assets as well as they know their clients. This challenge may not be easy to meet. After all, some of the financial instruments that are now in difficulty gained widespread acceptance in financial circles. There will be a lot of pressure in many areas in financial markets to increase transparency and revisit criteria for assessing credit-related securities. That will help, but in the final analysis, the financial advisor is the last defence between the client and the dangers in financial markets, and the credit-market turmoil of the summer of 2007 reminds us that it is a responsibility that must be taken seriously.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years’ experience as an economist, he leads Fidelity’s research efforts in retirement in Canada today. He can be reached at peter.drake@fmr.com.

(09/10/07)