Investing is like a mine field. You need to know the right path to take without getting blown up. The advice dispensed by many brokers and advisers is filled with mines. The problem is the mines are disguised as sage investment advice. One red flag is complexity. Another is the promise of increased return without additional risk.
Dominic Annino is an elderly widower and cancer survivor with a high school education. He is not a sophisticated investor. According to allegations of a complaint filed by Annino with the Financial Industry Regulatory Authority (FINRA), Annino told his Wells Fargo Investments broker that his goal was the generation of income, without risking principal. The broker suggested a reverse convertible security, which Annino understood would keep his principal secure, but would provide him with a higher level of income.
Higher income with little or no additional risk is a lure that most investors cannot resist. But reverse convertible securities are far from secure. They consist of a high yield, short term note issued by a listed company, that is linked to the performance of an underlying stock. When the note matures, the investor gets the return of his principal or, if the stock has fallen below a designated price, shares of the stock in lieu of his principal. Translation: If the stock drops dramatically, you can kiss your principal good-bye.
[See The Arrogance of Trading.]
That’s exactly what happened to Annino. Two of the stocks underlying his reverse convertible securities dropped dramatically in price. He lost $51,516 on one investment of $150,000 and $54,504 on another investment of the same amount.
A FINRA arbitration panel agreed that the safety of the reverse convertibles were misrepresented to Annino. It awarded him damages of $125,000. "Reverse convertible securities are complex, volatile products with a risk of 100 percent loss of principal and only a minimal upside,” says Michael Edmiston, co-counsel for Annino. “They are products of Wall Street's financial alchemists and are sold to yield-seeking investors in times of low interest rates and high market volatility."
Most investors aren’t so lucky. FINRA arbitrators have a well-deserved reputation for denying most claims outright or awarding only a fraction of the damages suffered as a result of broker misconduct. Complex, volatile investment products are created to be sold and not bought. The commissions are high, few brokers or clients understand the risks, and the underlying premise is fatally flawed.
Annino could have avoided his losses if he asked his broker to explain the risks of this investment in writing. Written communications from brokers have to be vetted by their compliance department. Some brokers will refuse to go through this process, which should be another red flag.
Annino should have been invested in a globally diversified portfolio of low management fee index funds, with a maximum exposure to the stock market of fifteen percent of his assets. He would have been able to easily understand the risk of that portfolio, and its historical returns would have exceeded his needs. Of course, the commissions would have been far lower than those generated by reverse convertible securities.That’s why brokers are highly incentivized to sell investment products that are clearly in their best interest, but not necessarily suitable for their clients. Don’t be fooled.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.