Question: When I buy a stock or pooled fund, I get either a stock certificate or a confirmation receipt only. I do not get something tangible in return that has actual value equal to the cash I shelled out. What am I really buying with these financial instruments and how do I convince myself that what I am buying is a good deal?—asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph and Facebook.
Answer: Your question applies practically to all sales of services where the benefits from such services are prospective.
The management of a company promises to do a good job of growing profits so that the debts are paid on time and the company’s stock price goes up. Pooled funds also promise to use their technical knowhow in finding and managing investments that can potentially produce the target returns sought after by their investors.
So, what is in a promise? Do people have more than just a piece of paper to hold on to?
A promise is a commitment to do or not to do something. Confirmation receipts do not even contain any promise. But more than the piece of paper, a person buying the promise must enjoy a relatively high level of confidence that the promise will be kept.
The confidence being sought after in the context of financial instruments where there are no guarantees of returns is based on trust. Paraphrasing Wikipedia, trust involves one party (the trustor) who is willing to rely on the actions of another party (the trustee). The trustor abandons control over the actions performed by the trustee in a situation where the trustor is uncertain about the outcome of the trustee’s actions. The trustor can only develop and evaluate expectations. This uncertainty involves the risk of failure to the trustor if the trustee will not behave as desired.
To minimize the risk of failure, the trustor can: Review the historical performance of the trustee; analyze the financial capacity of the trustee in fulfilling its promises, and assess the level of expertise of the trustee in keeping with its commitment. But to seal the deal, so to speak, the trustee must be able to demonstrate the level with which it prioritizes the interest of the trustor over its own.
Find financial instruments that will give you positive reviews on the foregoing four ways to minimize risk and you will see that you will be holding onto more than just paper in owning them.
Promises are meant to be kept and not broken. But you also need to do your homework to help minimize the risk of failure.