In today's nearly zero-yield environment, investors who seek predictable income find it hard to meet their goals. Some turn to complex or alternative investments and take risks they either do not understand or cannot afford.
A product might be considered complex if you have a hard time understanding how its features will interact under different market conditions and how that interaction may affect potential risk and return. Clues include novel investment strategies, complicated features or embedded use of borrowing.
"If investors do not fully understand the leverage and other risk and reward features of a complex investment, they should stop right there," according to Gerri Walsh, president of the FINRA Investor Education Foundation. "A good general rule is never invest in products you do not understand."
Take structured notes, one of many structured products offered to individual investors, for instance. Unlike corporate or government bonds, structured notes typically involve unsecured debt. Payouts are often linked to underlying assets such as a narrow or proprietary index or some other obscure benchmark. These notes may be marketed based on attractive initial yields, or a promise of some level of principal protection.
While some structured products are fairly straightforward, others are often complex and have cash flow characteristics and risk-adjusted rates of return that are hard to estimate. These products generally do not have an active secondary market, so investors must be willing to assume considerable liquidity risk.
Another example is inverse exchange-traded funds (ETFs). These products seek to deliver the opposite of the performance of the index or benchmark they track. They are often marketed as a way to profit from, or at least hedge exposure to, downward moving markets. Back in 2009, FINRA notified securities companies that inverse and leveraged ETFs that reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.
Similarly, investors seeking exposure to alternative investments might seek out alternative mutual funds. These funds might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities. They might employ complex strategies, including hedging and leveraging through derivatives and short selling. This can make it harder for some investors to understand the strategies and risks involved.
If your financial professional recommends you invest in these, or other, complex investments, ask these questions before you hand over your money:
• What are the costs? Complex investments can have embedded costs that have significant impact on your ability to weigh the risks and rewards of the investment.
• What are the liquidity risks? In many cases, there is no secondary market for the product. This will make it difficult for you sell no matter what the circumstances are.
• What is the worst-case scenario? Discuss your adviser's assumptions and recognize that your own worst assumptions may be too optimistic. Investors considering a structured product tied to an asset should look into the level of volatility of the underlying asset over the long term.
Reaching for a higher return almost always involves taking on more risk. Look beyond the number next to the percentage sign and realize, if you do not fully understand the risks and costs that you are taking on, then chasing yield usually means chasing trouble.
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