The Biggest Lie in Investing: Protection on the Downside

Imagine for a moment that you’re a small business owner in your late forties. Over the years you’ve worked hard to build up your company; a strip mall that consists of a car wash, gas station, and liquor store. With most of your assets tied up in the small business you don’t have much else in terms of savings. An opportunity presents itself and you receive an offer to buy your business. The net proceeds leaves you with $1.2 million; a sizeable nest egg on which you expect to retire and live comfortably for the rest of your life.

Not knowing much about investing or the stock market you seek out an investment advisor. You meet with a local advisor from a bank brokerage with the impressive title of First Vice-President. He says he can invest the proceeds from the sale of your business and not only provide a steady stream of income but also substantially grow your nest egg.

You agree to work with Mr. First Vice-President and he opens a fee-based account, charging a flat 1 percent fee to manage and invest your $1.2 million portfolio (for a fee of $12,000 per year). You fill out a Know-Your-Client form, saying that your investment knowledge is fair and you’re willing to accept moderate risk to achieve long-term gains.

Protection on the Downside

What transpires next is the biggest lie in investing. Mr. FVP promises that his investment approach can provide you with steady income and capital gains while also offering protection in case of a market crash. The truth of the matter, unbeknownst to you and your limited investment knowledge, is that Mr. FVP would pursue an investment strategy which involved a high degree of risk.

The approach that Mr. FVP recommends is something known as the Bull Put Credit Spread, an option strategy in which the client earns premium income while limiting the downside risk.

Bull Put Credit Spread: An investor will sell a put option to receive premium income and simultaneously buy a put option with a lower strike price on the same underlying security to limit downside risk.

According to the Investment Industry Regulation Organization of Canada (IIROC), while a spreading strategy does limit downside risk, the strategy still involves short term speculation on the price of the underlying security and has the potential to create short term trading and realized losses if the options are assigned to the client. In addition, the level of risk increases with the number of open options contracts.

Indeed, Mr. FVP entered into a number of contracts each month, and in certain months had as many as 15 contracts assigned to your account.

Mr. FVP also employed the use of margin, which further increased the level of risk in your account. In fact, the account was in a negative cash position for 25 consecutive months, with the level of margin reaching a high of approximately $715,000 against a market value of invested securities of approximately $1,282,000.

Finally, the portfolio had a high degree of sector concentration which further increased the risk level in your account. Up to 70 percent of the portfolio was invested in the energy sector.

Sadly, the downside protection didn’t materialize as your portfolio experienced a net loss of $463,587 over a three-year period, representing a nearly 40 percent decline. During the same time period, the S&P TSX Composite Index decreased by 7.4 percent.

Final Thoughts

This cautionary tale is unfortunately true and altogether too common. The advisor was fined $70,000 by IIROC after a hearing confirmed that he failed to use due diligence to ensure that his recommendations were suitable for the client. Fortunately, in this case, an agreement was reached with the client to provide compensation for the losses sustained.

By the way, if you’re thinking the advisor got what he deserved, think again. It turns out that IIROC only collected eight percent of fines against individuals in 2016. Unsuitable investments continued to be the top complaint received and prosecuted by IIROC.

This type of situation highlights the need for a best interest standard (rather than a suitability standard) which puts the client’s interests first and prevents unscrupulous advisors from putting their client’s retirement savings at risk with a ridiculous leveraged option strategy (all while collecting more than $12,000 in client fees).

The promise of investment growth AND protection on the downside is contrary to the very nature of investing, yet active managers promote this idea all the time as a way to beat the market, or deliver “premium income”, all while protecting your nest egg in case markets crash.

But there is no free lunch – if you want growth, you must be willing to accept risk. And be wary of advisors who use complicated jargon to fool investors into thinking they can have their cake and eat it too.