Beyond the Coronavirus Market: Five Red Flags Every Investor Should Heed

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Will the coronavirus crash the stock market? Who knows. But Peter J. Mougey says considering that “once in a lifetime” market crashes now happen once a decade, you’re better off worrying about investment issues you can control. Here, he shines a light on bad, life-ruining advice many investors get—and what you can do to recognize and avoid it.

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Pensacola, FL (March 2020) - The stock market is no fan of the coronavirus. To say it's been extremely erratic is an understatement. The last few weeks have been a rollercoaster ride of dramatic drops, rebounds, and more drops and rebounds. What will happen next is anyone's guess...but rising global (and national) death tolls promise more volatility to come. But Peter J. Mougey says if you're focused on the coronavirus and its effects, you're missing the bigger picture.

"There will always be market declines, just like we'll always have hurricanes," says Mougey, securities and investment fraud attorney with Pensacola, Florida's Levin, Papantonio, Thomas, Mitchell, Rafferty & Proctor, P.A. "You know how people talk about hundred-year storms? Seems like we're having them every year. And the same thing is true with the market. The coronavirus crash is just the latest hundred-year storm."

He reminds us that people called the 2008-2009 decline the worst since the Great Depression. But the truth is, seven years earlier in the tech-wreck of 2000 to 2002, the S&P declined 40 percent. His point? We are now looking at frequent market cycles of precipitous declines, and we have one every few years. What's more, "once in a lifetime" market crashes are happening once a decade.

"Four years in the 2000s alone, we had huge declines, and we've been on a bull market run from 2009 until today," says Mougey. "It's one of the longest sustained bull markets in the history of the stock market. We are going to have a crash. It's just a matter of when."

Looking Beyond The Coronavirus Crash

So what does this mean for you? First off: Don't react to the current fluctuations by panicking and going to cash. You'll end up making a bad decision that hurts you in the long run. Instead, ensure that you are well diversified with a good mix of securities so that when upheavals and declines happen, one area will "zig" while the other will "zag."

Second, make your investment decisions very carefully up front but always get a second opinion. Be aware of red flags that indicate you could be making a misstep that may set you up for disaster—no matter how the current pandemic shakes out.

Mougey—who represents investors who have sustained significant losses based on fraudulent activities or other investment-related wrongdoing—sees firsthand the grim results that occur when people make uninformed investment choices that turn out to have significantly more risk than what was explained. Here are a few of the biggest, scariest red flags he sees on a regular basis:

RED FLAG 1: Your financial advisor is too small (or too insolvent) to pay a malpractice verdict.

Certainly, there are many good advisors, but plenty of them are unqualified. Many have very little education or training; they simply passed a test that took a couple of hours. They routinely give bad, life-ruining advice, sometimes due to self-interest but often due to plain old ignorance. Too, brokers are often misled by the person who pushed a bad product on them.

The Financial Industry Regulatory Authority (FINRA) says every financial advisor has an obligation to provide "suitable" advice. And because so many break the "suitability" rule, there are lots of lawsuits. Unfortunately, says Mougey, 1/3 of every awarded FINRA arbitration is uncollectible simply because the financial advisor doesn't have the resources to pay a verdict.

"You can literally open a financial advisor office with virtually no capital and no assets except for a desk, chairs, and a computer," notes Mougey. "Make sure you're not working with a strip mall financial advisor. If they give you crappy advice and you have to sue, they may not be able to pay your verdict."

RED FLAG 2: Your advisor is pushing a product you don't understand.

Mougey says there are a lot of extremely risky products out there. For example:

  • Exchange-Traded Funds (ETFs) with Leverage—While there are various kinds of ETFs, some have significantly higher risk than others. Many use highly complex strategies that include derivatives. For example, market-linked ETFs can be very deceptive as many investors hold for a year. The problem is they reset every day and so become de-linked with actual market performance. Investors are often surprised when the ETF's performance looks nothing like the overall market.
  • Non-Traded REITs—These are illiquid investments that are not listed on an exchange, are extremely expensive, and carry substantial risk. Historically they are far outperformed by traded REITs.
  • Reversible Notes—These are structured products that are sometimes described as "debt instruments" but are far riskier and more complex. They involve factors that are extremely hard to evaluate, not just for investors but for advisors themselves.

Non-traditional products like these are 80 percent of what Levin Law litigates, says Mougey.

"These non-traditional products are really scary," he says. "They're very complex and have become increasingly so in the last 10 years. And they have lots of risks that aren't apparent at first glance. They're created because the firms underwrite them and make a ton of money off of the underwriting. Here's the bottom line: When you lift up the hood to see what's underneath a product, if you don't understand it, you shouldn't be in it.

"In fact, it's probably best to stay away from products altogether," he adds. "You don't need them at all if you simply follow the tried-and-true strategy of allocating between stocks, bonds, and cash while ensuring your portfolio is diversified across all industry sectors."

RED FLAG 3: Your portfolio is over-weighted in certain sectors.

Most people get the notion of proper diversification; i.e., your portfolio should be invested in various sectors and properly allocated between stocks, bonds, and cash. Not putting all your eggs in one basket reduces your risk of losses. Yet some financial advisors (Mougey calls them "stock jockeys") think they are smarter than they are and too heavily push whatever is hot at the moment.

For instance, a few years ago, it was the energy sector. Brokers thought, Well, the energy market has been very stable for the last 30 years. Then, when energy declined, it turned out a lot of people were over-weighted in energy.

"Everything's very stable until it's not," says Mougey. "Over-weighting in any specific sector makes no sense. It's called uncompensated risk, meaning you're taking risk you can diversify away and you often receive no additional returns for the higher risk. A lot of times, people in mutual funds assume they're weighted accurately, but this isn't always the case. My advice is to ask for a Morningstar report to show your sector weighting. Even just by pure mistake, you can be over-weighted and not know it. It happens all the time."

RED FLAG 4: Your advisor uses the words "margin" and "leverage."

Basically, margin means that you are borrowing money to buy securities. So, if you go in with $500,000, you can do what's called "leverage up," typically three times. You can borrow $1.5 million on your $500,000. Now your portfolio is $2 million. If the market declines 20 percent, do the math: That's 20 percent times $2 million. You lose $400,000, or 80 percent of your initial equity. In other words, leverage magnifies market movements.

"What happens is that there's one of those 'hundred-year market declines'—and I mean that in air quotes—and the bank sells out your portfolio to cover the margin loan," explains Mougey. "They sell at the bottom, and the market bounces back up, which it typically does, but you don't get the benefit. Your portfolio is now permanently impaired. It will never recover.

"I've seen this happen to all kinds of people, from elderly blue collar workers, to veterans, all the way up to wealthy, sophisticated people," he says. "Be very wary of leverage. These leverage strategies are pushed on people all the time because they're proprietary and they generate additional commissions and fees. The simple answer is stay away from leverage unless you have money to burn."

RED FLAG 5: Your advisor is encouraging you to take out 10 percent or more a year in retirement income.

If you retire and a financial advisor encourages you to take out 10 or 15 percent every year, you may be fine for a little while. But you will hit a year—or two, or three—of bad returns. Let's say you start with $1 million and you take out $100,000 a year. And then the market declines 10 percent. Now you have $800,000. At the end of year two, the market declines 10 percent again, and you have $600,000. At the end of year three, you have $400,000. In order to generate $100,000 now, you will need a return of 25 percent out of your portfolio—and that's almost certainly not going to happen. You've entered what Mougey calls "the death spiral."

"The academic and industry literature suggests portfolios can sustain only 4-5 percent over the long-term," he explains. "The further you get away from 4 or 5 percent, the higher the risk you'll be involved in a death spiral that you can't ever recover from.

"This happened to some mill refinery workers from Illinois I met with in 2005, who retired in late '99 and 2000," adds Mougey. "A financial advisor talked them into retiring early en masse. Most were in their early to mid-50s, making 50 or 60 grand, and retired with about $500,000. The financial advisor said 'Why work? You can make the same amount from your returns.' Then the decline happened, and their portfolios blew up. They lost their life savings. And they couldn't get their jobs back and ended up mowing yards and working on turkey farms pulling out dead turkeys. Now they're 65, 70 years old and still doing this kind of work—they have nothing left besides Social Security. That's what the death spiral looks like in human terms."

The bottom line? If something sounds too good to be true, it probably is. Proceed with caution.

"There is a lot of greed out there, a lot of bad advice," says Mougey. "Wall Street is powerful and self-regulated. Sure, there are some ethical advisors, but overall there's no real deterrent to financial malpractice. Instead of worrying about events you can't control, educate and protect yourself. Your future depends more on the decisions you're making right now than it does on the coronavirus crash and whatever ups and downs it brings in the near future."

Peter Mougey is a partner in the Pensacola-based law firm Levin Papantonio and the chair of the firm's securities department. He concentrates his practice in the areas of complex litigation, financial services, securities litigation, and whistleblower or qui tam litigation.

Levin, Papantonio, Thomas, Mitchell, Rafferty & Proctor, P.A., has been in existence for more than 65 years. It is one of the most successful plaintiff law firms in America. Its attorneys handle claims throughout the country involving prescription drugs, medical devices, defective products, securities, and consumer protection.

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