Our firm recently lost a client. When we lose a client, which happens from time to time, we always reach out to that client to thank them for their business and ask why they left. This particular client had a family friend who is a financial advisor and the client wanted to consolidate accounts with that friend. Totally understandable. The client also mentioned the name of the new firm which I quickly researched out of curiosity.
The firm website stated that the investment strategy used by the firm involves selling options contracts. This is an immediate red flag for me. Stock options are complex investment vehicles that few people understand. Selling “call options” against a stock or portfolio involves two parts: you give up your “upside” in a particular stock or index and in exchange, the person who bought your calls pays you a “premium” for doing so.
Here is an easy example: you buy the S&P 500 index via $SPY. You sell calls that pay you a 2% “premium” on your investment – the calls “expire” in one year. In return, you are required to give away your shares if the S&P rises more than 10% in that one year time frame.
On the surface this sounds great: stocks average about 10% per year* and you just added another 2% on top of that increasing your potential annual returns by about 20% (two divided by 10). The issue is that while stocks average about 10% per year over the last 100 years, the market has huge moves to the upside and downside that get you to that 10% average return number. By giving away your upside after 10% you miss out on the big gains stocks see in bull markets such as the 21% gain** in 2017 and the 32% gain** in 2013.
The other important thing to note is that selling call options caps your upside but still gives you 100% exposure to all the downside risk of stocks (minus the “premium” received). Getting a 2% annual premium is small consolation in years like 2008 and 2002 when the S&P went down 37% and 22% respectively. To sum up the strategy: you give up many of the great years typical of a bull market while being exposed to almost all of the downside we see in bear markets.
When an investment strategy sounds too good to be true, it probably is. Holding a simple diversified portfolio through good times and bad is not that “sexy”, but sometimes boring is better.
**returns from morningstar.com
***The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.
****Securities and Investment Advisory services offered through Ausdal Financial Partners, Inc, 5187 Utica Ridge Road, Davenport, IA 52807 (563)326-2064. Member: FINRA/SIPC. M.Brown and Associates and Ausdal Financial Partners are independently owned and operated