Heads you win, tails they lose. That’s how Mordechai Levitansky’s broker described the investment products he was recommending. Mordechai was concerned that the stock market would crash, and along with it his savings. In 2008, when stocks had plummeted, he’d sold out after losing a punishing 50% of his investment. After tiptoeing back into investing years later, he’d done pretty well, but it seemed like the market had recently risen too far, too fast. Mr. Levitansky wanted to remain in the stock market but along with protection on the downside. His broker said that the large Wall Street firm he worked for offered two products which allowed investors to get the gains of the stock market with minimal or even no losses! Mordechai was now all ears, as these options sounded perfect for him.
One product offered was a mutual fund, mostly invested stocks, which also bought insurance (using options) to protect the stocks from falling too far. Indeed in 2008, when the stock market had dropped by 37%, this fund had lost just 13%, so apparently the insurance had worked. The other offering, called a structured product, was a contract whereby the broker’s firm promised that money handed over to them would be returned, principal guaranteed, after a set number of years with profits. The actual calculation of the gains was complicated, but although the investment was guaranteed never to fall, the contract value would grow at the same percentage rate that the stock market did within the contract period. Being able to invest in the stock market without potentially losing money seemed like a dream come true! Is it possible? Can Mordechai get guaranteed high returns?
As Likely as Healthy Cake
Guaranteed high returns make as much sense as zero calorie cake or getting fit while sitting on the couch. When an investment offers significant returns with little risk, you can assume that there is an exaggeration or misunderstanding of either the loss guarantee or the profit potential. How can any company absorb everyone else’s investment losses while giving away the gains? And, why would they do so? Government regulators have issued multiple warnings that these complex products are not as they seem, encouraging extra caution when dealing with them. They also have fined various Wall Street firms including Merril Lynch, UBS and Wells Fargo for not properly disclosing the hidden risks of structured products. Many such “guaranteed” investments imploded during the financial crisis of 2008, so they should be approached with a healthy dose of skepticism.
Safer, But At What Cost?
Guarantees and insurance can indeed make investments safer, but because the cost of such coverage is substantial, it usually dramatically limits the investments’ potential. Imagine someone who makes cars safer by slowing them down to a maximum 15 miles per hour. While they would be very safe, for all practical purposes, these vehicles aren’t cars anymore but very expensive go-karts. Travelers who wish to arrive within reasonable time frames will still have to travel at high speeds and accept the risks involved. Similarly, while the “insured” stock mutual fund Mr. Levitansky’s broker mentioned is a lot safer than a regular stock fund, it also is very “slow,” that is it has limited potential returns. Indeed, over the past 15 years, the insured stock funds’ growth was materially lower than the stock market’s Of course, it’s okay to lower your risks, but don’t let someone convince you that doing so isn’t going to limit your profits as well.
A Parachute Guaranteed To Work– Sometimes
“Predictions are hard to make especially about the future.” While the origin of that quote is disputed, no one doubts that it’s tough to guarantee anything absolutely. A repayment promise that’s too generous will quickly bankrupt a company, so companies are careful to limit guarantees. The stock market protection built into the contracts offered by Mordechai’s broker is likely limited as well, the nuances contained in the prospectuses that virtually no one reads, (a big mistake). One common limitation is that protection is only on the first 10-15% of stock market losses: catastrophic losses are not covered. Another is that in case of a crash, the guaranteed sum will only be paid out over many years, which is a lot less useful than an actually guaranteed repayment. The most considerable limitation on an investment guarantee is the ability of the guarantor to make payment even after a widespread crash. Lehman Brothers’ and AIG’s investment guarantees were worthless in 2008: Is the company offering the contract to Mr. Levitansky any better?
The prevalence of these undisclosed limitations is highlighted by an ironic lawsuit brought in 2012 by Edward Dulin, a former broker for investment company UBS. Dulin sued his ex-employer for not disclosing to him how risky the “guaranteed” products he was selling on their behalf were! When Mr. Dulins’ clients sued him successfully for their terrible losses, he turned around and sued the company. In 2014, Dulin was awarded $5.4 million to compensate for his financial losses and reputational damages caused by the sale of these complicated investments. It is not unusual that brokers selling these guaranteed products do not truly understand how they work, and perhaps never even read all the relevant prospectuses and contracts. Where does that leave their clients?
Complexity: Both A Sign and Cause Of The Problem?
The costs and limitations of insured or guaranteed investments make them a lot less attractive than Mr. Levitansky’s broker is letting on. And the documents outlining these costs and limitations are dense and complex. Complexity is both a sign and a cause of an investment’s weakness (both siman and siba in Yinglish…ask your local yeshiva bochur). Complication is a cause of poor investing because it increases the likelihood of incorrect usage. It’s also a sign of an offering which will not work well in many cases: the many pages of loopholes are describing the ways the company won’t deliver. While these products may still make sense for Mordechai, he must proceed with caution.