Sunday, 8 February 2009
The Collapse of Storm Financial
Storm Financial encouraged its clients to take out margin loans secured against their houses and use the borrowed money to invest on the stock market. According to a member of Aussie Stock Forums, Storm Financial used the borrowed money to invest in ASX200 index funds.
Such a plan worked fine during boom times, but things turned bad for clients when the market went south.
Many people say that it is important to be optimistic and to have a positive attitude. I believe that always being positive is very dangerous when you are investing. One thing investors should be careful about is leverage, which is borrowing money to invest. Borrowing money to invest is a great idea if the asset you invest in goes up in value by a greater rate that the rate at which you borrowed. However, you are often uncertain about whether a particular asset will perform that well. You are also uncertain about whether you are capable of paying back the loan. Borrowing to invest is very risky.
Another lesson you should learn is to be cautious about financial advice. Storm Financial charged hefty fees and used this money to pay celebrities who in turn promoted the product. You should be careful about financial advice you get from other people. Try to ask as many different people as you can. Think carefully about their justification for why an investment is reasonable and make sure it makes sense.
Another lesson is to diversify. Leveraging into an ASX200 index fund through Storm Financial does provide diversification because you are investing in 200 companies. However, you are putting your faith in one firm. If that one firm collapses, you are in big trouble. Those who invested all their worth with hedge fund manager Bernie Madoff would have lost everything as well. Even the Bible recommends diversification. Ecclesiastes 11:2 says, "Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth."
Storm Financial and Bernie Madoff are different. Bernie Madoff actively deceived investors, telling them that he was investing in options and other fancy investment products. In reality he was running a pyramid scheme. I am not aware of the full facts but it seems as if Storm Financial actually told its investors exactly what would happen, which is that they would borrow money against the house and buy shares with the borrowed money. A pyramid scheme is illegal but borrowing money to invest in the stock market is certainly not. It is a legitimate way of investing.