Investor Sold Short by Adviser's Bad Advice

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Posted: Mar 12, 2009 12:01 AM
Investor Sold Short by Adviser's Bad Advice

Body text:Q: My coworker recently sold all his equity position in his portfolio because his adviser told him to get reverse ETFs. He said his adviser stated, "While others are crying because the markets are going down, you will be laughing because your portfolio will be going up." What are reverse ETFs and do you like them?

A: Your coworker is a moron, exceeded only by his adviser. A reverse ETF is nothing more than a fund that engages in short-selling (selling a stock the seller does not own) and, in some cases, options trading (trading contracts that give the buyer the right to buy or sell a security at a specific price on or before a certain date). The point is to invest in a manner that profits from declines in the stock market. So what's moronic about it? If the adviser were a genius, he'd have told his client to sell everything and buy the reverse ETFs in October 2007, when the Dow was 14,000 -- not after the Dow fell below 8,000! Short-selling is speculative. Stock prices can rise forever, but cannot fall below zero. That's why people are willing to buy stocks. Losses are limited, but profits are potentially unlimited. It's the opposite for short-sellers: The profit potential is limited while the potential for losses is unlimited. In short, this idea is nothing more than another get-rich-quick scheme that's fraught with pitfalls. Your friend is taking massive risks, while his broker will profit no matter what thanks to the commissions he earns as your friend tries to play this game.

On second thought, maybe that broker isn't a moron after all.

Q: On your radio show, you said it was ironic that risk-adverse investors (those who kept their money in banks or Fannie Mae or Freddie Mac bonds) are the people who are getting hit the worst in this financial crisis. But bank depositors haven't lost a dime. Likewise, holders of Fannie Mae and Freddie Mac debt were made whole due to the government bailout. It was the common and preferred shareholders who got wiped out. Therefore, the ultraconservative investor who you criticized would have preserved all, or nearly all, of his principal while making positive returns on his investment.

A: True. People who spent all of 2008 in bank accounts are happy that they avoided the problems incurred by investors of stocks and bonds. But let's not evaluate an entire movie by studying a single frame of film. First, you assume that CD depositors keep their investments within the FDIC limits. What about the 82-year-old widow who called me in distress after learning that her $800,000 life savings was largely wiped out when her bank failed? When IndyMac bank failed, it was holding $10 billion in deposits in excess of FDIC limits for thousands of depositors.

Or consider the high-net-worth couple that lost $3 million when they sold the bonds they owned in a panic. They purchased them from Freddie Mac and Fannie Mae because they assumed that such "government" bonds were safe. Finally, and most importantly, noting that bank depositors are better off than stock investors because stocks fell this year is a shortsighted and inaccurate comparison. Sure, for the most recent 12-month period, you're right. But try that comparison over any 20-year period of your choosing and you'll see vastly different results. Over long periods, bank depositors will find that their money will have been severely eroded by taxes and inflation, while the investor willing to tolerate occasional volatility will have enjoyed true growth of principal.