Product liability is something we all understand when it comes to cars, cookies and toys. But did you know the idea also applies to investments?
In consumer products, product liability comes into play where the manufacturer shouldn’t have put something on the market because it’s unacceptably dangerous. When it comes to investments, it’s pretty much the same idea. A “dangerous” investment product is something that the “manufacturer” (i.e. the brokerage house) should not have sold to an investor because it’s not “safe” for them. That is, it’s not a suitable investment for them.
In my securities arbitration practice, I see clients after they’ve lost a lot of money in a variety of investments. When the investments tank, they’ll ask their broker, “How could this have happened? You said it was safe!” And the answer they’ll get is, “Well, that’s the market. There are no guarantees.” Yes, there are no guarantees. But there are also instances when the investment was defective – whether by flaw in the design or for the particular investor.
Now, I want to be clear – most brokers are good and honest and they thrive on making money for their clients. True, there are some brokers and some brokerage houses that are not so trustworthy and their clients suffer. But the root of a defective investment doesn’t really lie in dishonesty. It lies in being different and often complex, which makes it difficult to fully understand or appreciate the risks. If complexity is the “root” of a defective investment product, the broker’s inability to understand it is the “stem”. Even there though, sometimes it’s not the broker’s fault. Brokerage houses develop the latest and greatest investment products and expect, and often incentivize, brokers to sell them over other products. For the house, selling is primary and understanding is secondary. Brokers rely on their houses to identify the type of investors for whom the product might be right and to explain why. If the house is wrong in its identification or explanation, it sets the broker off in the wrong direction which can be catastrophic for the investor. That can result in investors putting their money into investments that are simply not right for them. For these investors, these products are just as defective as a car with a faulty braking system or a toy that flies apart in the face of a child.
So how do you know whether you should consider a financial product “defective” for you? Here are a couple of questions to ask yourself:
- Have you ever heard of it? Most people have heard of stocks, bonds, mutual funds and annuities. How about a reverse convertible security? Guaranteed deposit, anyone? Would you like some mortgage backed securities? I’m not saying that all investment products you’ve never heard of are defective. I am saying that you should be on alert if your broker suggests something that’s alien to you. The more esoteric the product, the greater the need for caution, and education.
- Does the broker understand it? If brokers can’t clearly explain an investment vehicle that’s a problem. Of course, it can be difficult to tell whether the broker really understands it. After all, selling this product is their job. That’s where questions enter. A few of my favorites to ask at the beginning are “How does the issuer make money from this investment?”; “How does the brokerage house make money from selling this investment (and how much)?”; “How do you make money from selling this investment (and how much)?”; and “How does the amount the house and you make from selling this investment compare to what you would make selling other investments?” If the broker or the house makes more from selling this product than others, you’ll want to ask why. Then you’ll want to ask as many questions as you can about the product itself and the market for it. The goal is to penetrate deeply into the product because that’s where the lack of understanding gets exposed. Think about it like a car. You can expect the salesperson to be able to tell you that the car has fuel injection, but can the salesperson explain how fuel injection works and why it’s good?
- Are the materials provided by the brokerage house clear and direct? Both the salesperson and the investor should be able to understand the investment; how they will benefit from it; and the exit strategy if they aren’t happy with the investment. If not, they need to dig deeper before investing. Sometimes the materials are so complex that even investment professionals can’t comprehend them. So, the broker relies on a summary someone else prepared. This is not a good sign for an investor and should be a warning that they need to delve deeper or walk away from the investment.
How can you avoid putting your money in a product that’s not right for you? Here are a few suggestions:
- Be wary of something that’s not traded on a recognized exchange.
- Read and understand the prospectus, the offering memorandum, or whatever written information you’re provided to introduce to the product. Ask questions if you don’t understand it. Don’t just rely on the marketing materials from the company or the summary prospectus. Again, think about cars. Glossy brochures make everything look wonderful. The dangers are hidden in the drab technical specifications.
- Ask another financial professional such as a CPA or securities arbitration attorney to read over the materials and explain them to you.
- Make sure you fully understand not only how the product works, but the risks inherent in it. People sometimes focus too much on the potential reward when the risks should be front and center.
- Avoid investments you don’t understand. This philosophy has worked quite well for a sophisticated investor like Warren Buffett, so you can expect it will do the same for you.
- Ask the broker for the educational information about the product the brokerage house gave him or her. These materials can be a lot different from the materials the broker gives you. If they say they can’t give them to you, be cautious. If the excuse is that the information is proprietary or confidential, it’s understandable. There’s a lot of competition in their world and they may not want that information to get to their competitors. So, ask if you can read the materials in their office and under their supervision.
- Ask about the size of the offering and how far along they are in selling it. Here you can think about the investment as a multiphase condominium development. What happens if they sell only five of twenty units in Phase I? Does Phase II get built? Or will I have a view of an overgrown empty lot and unit I can’t sell because of it?
- Google it. Learn what you can about the type of product and the particular issuer involved.
- Understand the exit strategies available to you. This requires you to understand whether there is a market for the investment and what it looks like. The more unusual the product, the smaller the market will be when you want to sell. You may not even be able to sell because there is no market – no buyers for what you’re selling. You want to know about its anticipated liquidity in case you want, or need, to get out of it. If it will be difficult to exit, you need to increase the risk value you assign to the product.
In the end, you have trust yourself about whether a product is “defective” for your purposes. And, as with most purchases, the old advice of caveat emptor applies – buyer beware.