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Thankfully, I don’t mean these kind of functions

Some weeks ago, I mentioned that I was going to do a piece of how individuals can get better at investing or finance by concentrating on function over form.

So I guess the first thing to answer is: what’s “Function over Form”?

Function over Form

I guess the simplest way of putting this would be to focus on the substance rather than the appearance of the subject. In other words, what the object/subject does rather than what it looks like.

For example, to most people, there is a stark difference between a Mercedes-Benz versus a Toyota. However, that is the form. The function, which is getting the person taking the car, from point A to point B.

Of course, people will argue that owning a Mercedes-Benz has other functions such as signalling to others that one is wealthy or it may provide a more comfortable drive (in my experience, this is marginal).

However, my argument is that those are secondary functions and the primary function of any vehicle is to get you safely from point A to point B. Once the focus shifts from primary to secondary functions, you know you’re in trouble as far as making sound financial decisions are concerned.

My epiphany

My realisation of how people lose sight of function in finance came when my wife and I met up with some financial advisors over the mortgage insurance that we currently are paying for.

In Singapore, regulation requires homeowners to take out mortgage insurance so that in the event something unfortunate happens to one of the mortgagees, there will be no problem paying off the mortgage. In a way, this makes sense because the government doesn’t want to have to deal with the scenario that the home has to be repossessed and the existing homeowner gets kicked out onto the streets.

The financial advisers we were meeting with suggested that we switch over to a term insurance that would cover us at a cheaper or somewhat similar rate for a longer period of time as the mortgage insurance only covered us until the end of the mortgage for an amount that was declining as our mortgage got smaller.

That made me realise that if the purpose of a mortgage insurance was to make sure that either my wife or I wouldn’t have trouble paying our mortgage should the other meet some unfortunate circumstances, then it doesn’t necessarily need to be branded as mortgage insurance. A term insurance for the length of the mortgage would have done the same job.

Unfortunately, these things aren’t so clear especially when the bank providing the mortgage suggests that you bundle the insurance in order to get a “good” rate on your mortgage.

Other areas of application

There are other areas of personal finance where it might also pay to pay attention to function over form.

(a) Whole life policies

For example, financial advisers in Singapore love to sell whole life policies on the pretext that on top of protection, you will get your money back after the duration of the policy whereas term policies merely expire.

The problem I have never heard any of these advisers point out that the above isn’t an apple to apple comparison. If we focus on function over form, we should realise that a whole life policy is effectively providing protection from unforeseen circumstances AND a savings plan.

Therefore, one should be comparing the premiums and returns on a whole life policies vs. the combination of a term policy and the returns on a fixed-income investment of a similar maturity.

For example, if the financial adviser is recommending a 30-year whole life policy, then the comparison should be made against buying a 30-year term policy and putting the difference in premiums paid into a fixed-income security of a similar maturity.

(b) Buying a house

Home ownership is one of the biggest myths that Singaporeans love to believe in and just like all myths, there are some truths to it but when EVERYONE believes that it’s the thing to do, you can bet your last dollar that it won’t work out for some people.

Buying a home effectively provides one function- a roof over your head. The alternative would be renting. However, buying a home for most people means taking out a mortgage and therefore, the total price paid for the home is higher than the sticker price. On top of that, there are associated costs of taxes, renovation and maintenance.

Of course, if you rent, we can assume that a rational landlord would have factored the costs of owning an apartment (such as interest, maintenance and other expenses) into your rent but this could be higher or lower depending on the state of the rental market at any point in time.

Therefore, the main question on whether to own a home or not, boils down to whether you think rents are likely to go up by much in the future. In short, what is your view on expected inflation?

I don’t want to go into too much detail on the tradeoffs because The Economist did a nice feature which you can watch here.

The main thing is that when you buy a home, it’s an expense. If you buy a home and treat it as an investment at the same time, you’ve effectively bought an investment in conjunction with a housing expense.

To conclude

You would do better at managing your finances if you break down the function of your investments and purchases, then no matter what the salespeople say, you won’t get hoodwinked.