OUR BLOG ON:
The Snag in the Sell Signal System
Many financial advisors promote themselves as having a special technique to predict the rise or fall of mutual fund investments, and convince clients to buy into the concept of a sell signal system that will protect them when those investments take a downturn. There is a serious snag in this system.
A sell signal is triggered when an investment loses value to an amount that a financial advisor and client have flagged in advance, for example a loss of 10%. When the investment reaches this level of loss, the sell signal takes the form of a telephone call, e-mail or letter that warns the investor to take corrective action – to sell the investor’s units in the fund.
While a stop-loss order given to a securities dealer in anticipation of a security’s decline can operate automatically, it cannot do so in the case of mutual fund investments. Each sale of a mutual fund requires a specific order from the investor. Therefore, the sell signal can only warn the client to call the advisor, or warn the advisor to get instructions from the client, in case the financial circumstances of the client have changed since the time the sell signal was put in place.
Therefore, in the case of mutual funds, the sell signal operates strictly as a warning system.
A Systematic Weakness
When a sell signal is triggered, the client or the advisor may choose to accept or reject it. For example, the client may reset the signal for a further 10%, and when that signal is received, may again reset it for a further 10% loss, likely thinking – or hoping – that the downturn can’t get any worse. As so many investors have learned since 2008, the market downturn can, indeed, get much worse! Therefore, the decision to sell is not automatic and so the sell signal has a systematic weakness – human error.
For this system to be effective, the client must accept the sell signal in every case, including those in which the investment value recovers immediately after the sale. A client who sees a mutual fund sold on the basis of a sell signal on Monday subsequently increase in value by 10% by Friday can easily lose faith in the system and stop accepting future signals. In other words, the system will succeed or fail according to human emotion.
A Further Weakness
Another snag in this system involves the use of leverage, meaning an investor has borrowed money to buy some or all of the mutual funds. The sell signal identifies a 10% loss in the value of the mutual fund, but the actual loss to the client may be far greater than 10% if all or part of the money to purchase that fund was borrowed. The sell signal is set according to the value of the fund and the change in that value over a period of time; it doesn’t factor in how much money was borrowed to purchase the mutual fund in the first place. In other words, it does not “know the client” or how much money the client has actually lost. For example, where a client invests $10,000 (known as equity) and then borrows $90,000 to invest (as leverage), the total invested becomes $100,000. A 10% decline may seem like only 10% of the amount invested, but it wipes out the entire equity invested and leaves the investor with only enough to repay the leverage loan.
The “System” that Works
Before 2008, both industry experts and investors believed that markets were efficient, meaning that the value of the security (whether a mutual fund, a market index, or an individual stock or bond) reflected all the information available about that security. After 2008, we are not so sure. What we do know, however, is how much the investor paid for that security.
A drop of 10% in that price may or may not reflect the proper value of the security at that time. A sell signal based on the change in price alone cannot replace the analysis of whether the investor should continue to own that mutual fund or should immediately sell it. Therefore, the sell signal system simply doesn’t work.
What does work is a complete system, one that involves regular portfolio reviews with your financial advisor to determine how to adjust your portfolio to reflect changes in the market and changes in your needs and your risk tolerance.
Fighting for Your Rights
John Hollander & Harold Geller
We represent clients who have suffered a loss due to the performance of their financial advisors. In some cases, the loss may have resulted from the use of a sell signal system, and/or the use of leverage. If you think that you have suffered such a loss, contact us for a free, no- obligation consultation.
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The Snag in the Sell System Signal