There has been much talk in the media about the Westpoint collapse. Westpoint ran a number of investment schemes where people lent money to Westpoint for a promised return of about 12%. The money was used to finance property development schemes. Many of the investments seem to have been recommended by financial planners who, according to media reports, were receiving commission payments of around 10%. At this stage reports are that $300 million has been invested in these schemes. The reports also suggest that the average investor has each had about $80,000 to $90,000 invested in the scheme.
This is a terrible state of affairs, and nobody can be anything but sympathetic for the small investors who have lost their money.
I think that there are five key investments lessons that can be taken from this debacle.
Let us look at these one at a time:
Know How Your Financial Advisor is Being Paid
As you know from reading the rest of this website, I am not in favour of commissions as a way of paying financial planners. There is potential for a planner to be unduly concerned about the level of commission received, rather than finding the client (you) the best financial solution. The usualy maximum up front commission for recommending an investment is about 4%. Most financial planners will charge less than this. If your financial planner is recommending a product that pays upfront commission of 2.5 times this amount you absolutely should be suspicious! If nothing else the question should be, 'Why do Westpoint have to pay a financial planner so much to recommend their investment?' When dealing with a financial planner make sure all fees are disclosed, make sure you understand the fees and be suspicious about any fees that are out of the ordinary.
Understand Your Investment
The Westpoint investments were in 'mezzanine finance' for property construction. Many investors have said that they did not understand what they were investing in. Mezzanine finance provides the funds for the development that the bank is not prepared to loan. For example, a bank may be prepared to loan $8 million against a $10 million property development. If things go wrong the bank will have the claim over the assets of the development. The remaining $2 million will be funded by mezzanine finance, possibly with some of the owner's own capital. The mezzanine finance is significantly riskier than the bank finance, because if the properties do not sell at the anticipated prices, or take too long to sell, or tenants can't be found, the bank has first claim over the assets of the project.
Keep in Mind Risk and Reward
The Courier Mail on the 4th of March reported one investor as saying that their financial planner had described the scheme as 'like having money in a bank account'. If true, this is simply a dishonest statement by that financial planner. If investing in Westpoint mezzanine finance was really like having money in a bank, Westpoint would only have to pay 5% to 6% to attract investors. Instead they had to offer returns of 12%, which is more than twice the rate of return available from the highest earning cash bank accounts.
More than this, after paying 10% commissions, the actual remaining 90% investment would have to earn a return of just over 13% to provide a return of 12% on the total money invested. A return of 13% is slightly higher than the long term return on the Australian sharemarket. This implies that an investment offering these sort of returns must be riskier than a sharemarket investment.
ASIC (Australian Securities and Investment Commission) have a consumer website entitled FIDO. This website warns about any investment offering higher return carries a higher risk, and that higher return should be a signal to you that there is higher risk.
It seems that if people had $80,000 to $90,000 invested in Westpoint, then this is likely to have represented a fair proportion of their overall capital. The idea of diversification is a simple one, don't have all your eggs in the one basket. Consider the difference between a more prudent investor with 10% of their wealth in a Westpoint investment and a less careful one that has 50% of their wealth in Westpoint. Let us assume that none of the money is able to be recovered. The prudent investor has lost 10% of their wealth, a bad situation although one that he or she will be able to recover from. The less careful investor will have lost 50% of their wealth, a situation that will be far more challenging to recover from.
Don't Rely too Much on an Auditor
The role of an auditor is to test a sample of transactions and to form an opinion about a companies financial statements. It seems that auditors are quickly blamed when a company or investment fails. Maybe this is a sign that people put too much faith in the audit report.
It is always worth reading the audit report in any company report, and checking that the auditors have delivered an unqualified audit statement. However we should acknowledge that this is only part of the process of preparing and checking financial statements, and that audit reports are only based on the examination of sample transactions, and should not be relied on too heavily.