How to be a better investor: episode 3
Products, services, what is what in the world of finance—and how to look out for yourself
Ruslan: What’s the difference between a financial service and a financial product?
Saf: A financial product is something you buy and own, like stocks.
James: A financial service is when someone performs an action for you that you would otherwise have to do yourself or leave undone, like your taxes
Ruslan: Ok. I want to buy life insurance to protect my family after I pass, but I don’t understand the terms and conditions, so I use a financial advisor. That’s a…… (Pauses uncertainly)
Saf: The advice is the service.
James: The insurance is the product.
Ruslan: This is confusing. Which do I need?
Saf + James: Both
Ruslan: Argh! How do I know if it’s worth it!
Saf: Well, there’s ways to make sure you get value from both. When vetting financial products there’s two rules.
Rule 1: DON'T buy anything you can’t explain in your own words
Rule 2: Know why you’re buying it – and compare, compare, compare!
Ruslan: What about service
James: Ask questions. Lots of questions.
Ruslan: Like what?
James: How is your advisor getting paid? An hourly fee? Commissions? Something else? If they’re being paid based on what you buy, then are they selling you what’s best for you? Or what makes them the most money?
Ruslan: Wait. What about the advisor from my bank?
James: Ah. See, he’s an advisor that also sells products. Make sure you’re being shown more options. Not just the products from their bank. You have to look out for you!
Don’t Get Hosed When Buying Financial Products and Services
Way back in another life, I worked in the mortgage department of a local bank running credit reports for mortgage preapprovals. I heard a lot of unfamiliar terms while working there, but the one that was the strangest and most puzzling to me was "financial product." The idea that a loan could be considered a product was completely foreign. The house was a product, clearly, but the mortgage? It made my head spin.
In the years since, I've come to understand how mortgages really are products. Each type of mortgage has different attributes and ways that it "works." In this way, a mortgage is just like any other product on a shelf. Each is devised to meet a certain need and has specific traits that you as a customer can use to distinguish between them and choose which best suits your purposes. But here's the thing: Many people I talk to don't know the difference between a financial product and a financial service, and that's a problem.
Products and services are regulated differently, and that can have a big impact on you as a customer. In countries like Singapore, for example, all financial products go through a deep vetting process where the regulating body determines if the terms and conditions are fair and meet a baseline standard of safety for the average investor. The process is slow, and it results in fewer options for customers, but it does provide a bit of protection for the uninitiated since there are few, if any, predatory products available. However, it requires a lot of resources to oversee this process, and one could argue it is too much regulation for a free market system.
In North America, our markets are based on the principle of "caveat emptor," or "buyer beware." In other words, the responsibility of determining if a product is beneficial or predatory is placed mainly on you, the buyer.
For this reason, in the United States, products are regulated mostly on the basis of disclosure. Companies that sell financial products are required to disclose the terms and conditions of those products to the customer. You know those impenetrable documents of legalese that you have to "read" before signing your mortgage or buying stock? Yup, that's what passes for open and transparent disclosure of a product. If, after being offered the disclosure, you still sign the agreement and get hosed, then it's caveat emptor, my friend. Caveat emptor.
So, let's say you want to buy life insurance to protect your family's lifestyle in the event of your untimely demise. You begin to read the disclosures for a few products, and it becomes clear that you could use some help understanding the terms and differences. So, you hire a financial advisor to help you. Now, advice is a service, and services are regulated differently than products.
Services are regulated on the basis of qualifications and conflicts of interest, but that doesn't mean that just because an advisor has a certification of some sort that he is going to put your best interest first. There are plenty of firms that blur ethical lines, push limits, and then there are flat-out fraudsters who have not yet been caught. When you hire an advisor, you can't depend on the government to have completely vetted his trustworthiness. You still need to adhere to the idea of "buyer beware." One of the ways you can beware when vetting financial advice is to have a clear understanding of how the person you are hiring gets paid. Knowing that can help you understand his financial incentive.
Imagine walking into a clothing store where the salespeople earn a commission on everything you buy and saying, "I know nothing about clothes or style. Please just tell me what I should buy, and I'll take it." You would never do that! Not because the salespeople aren't good at what they do or don't deserve the commission--that's not the point. The point is that they are incentivized by the company that they work for to sell you the most expensive wardrobe you will accept. We all know this model. There's nothing wrong with it, but as a shopper you generally want to avoid leaving the bulk of your decision in the hands of someone who has that kind of incentive. If your goal is to get a good wardrobe at a decent price, you shouldn't leave 100% of the decision in the hands of the salesperson. It's just not smart. The same thing goes for financial products and services.
Sometimes, it can be hard to tell whether someone is a salesperson or a serviceperson, and sometimes one person will play both roles. For example, when you visit the doctor and he diagnoses your illness, that's a service. If he then suggests that you buy a particular brand of medicine, that's a product. If you knew that the doctor received a commission if you buy the drug, would you weigh the advice differently?
Similarly, you may hire a financial advisor to help you create a plan to get from here to retirement. You discuss strategies for saving, investing, and what your life goals are. The advisor helps you understand the steps necessary to achieve them. This is a service.
If that same advisor sells you a life insurance policy and several mutual funds, these are products. The advisor has now switched roles from serviceperson to salesperson. There is nothing wrong with this, just as with a doctor or a hair stylist recommending a particular brand. You, the customer, simply need to know what you're buying, and how the incentives are structured so that you can weigh the product recommendations accordingly.
So, then, what's the smart shortcut for identifying and vetting financial advice and products? First, let's talk about simple definitions for each. Since these are rules of thumb, they aren't exact or perfect, but we're all about being "good enough" here.
A financial product is something you buy (including contractual agreements like loans) and take ownership over, along with the responsibility for complying with the terms of ownership. Examples are checking and savings accounts, stocks, funds, mortgages, and insurance policies.
A financial service is when someone performs an action for you that you would otherwise have to do yourself or leave undone. Most often in the financial profession, services involve the application of expertise. Examples are financial planning, investment advice, tax preparation, and legal consultation.
Rules of thumb for vetting quality are a bit tougher, but here's my best shot:
When vetting financial products:
1) Don't buy anything you can't explain clearly in your own words.
2) Decide on a few attributes that matter most to you and compare at least a few options. For example, when comparing shares of stock, you may care most about past performance and strength of the brand. With loans, you may care most about the interest rate and whether or not there is a prepayment penalty. If you can't name at least a couple of product attributes that matter to you, then you don't understand it well enough (see number 1).
When vetting financial services:
1) Understand how the person gets paid. Does the advisor charge an hourly fee? Earn commissions on sales? Take a percentage of earnings? Some combination of those? Then make some decisions about how the financial incentives might affect the services rendered and adjust your cost-benefit analysis accordingly.
2) If you are working with an advisor who also sells products, make sure that you are being shown more options than just the ones they sell. If you are paying for expertise to help you make the right choice of investments for your needs, then you should know that you are being shown the full menu, so to speak, and not only the few options that they are selling.
Bottom line: Financial products and services can be confusing and often purposefully opaque, but the responsibility of protecting your own interests while navigating this landscape falls on you, the buyer. Knowing the difference between financial products and services is a first step in vetting the advice you receive and the products you are shown. It's your responsibility, so remember that, and caveat emptor!
The additional reading is by Sarah Newcomb, a member of Morningstar's Behavioural team.