The Perfect Storm wipes out Baby Boomer Nest Eggs

Today I finally caught up with the the tragedy of the Storm Financial Group. This Australian Financial Planner’s Group had several thousand investors, many of whom were baby boomers who have lost most if not all of their wealth.

It appears that home owners with lots of equity in their homes were sold on the idea of taking out most of that equity as a mortgage and then applying for a margin loan to double up on the capital amount and then to invest all of it in a stock index fund.

The Storm Financial Group was established in 1994 and had been using this investment strategy for much of that time it seems. Through luck they had managed to live through several market retracement and managed to keep their clients fully invested to achieve greater returns. It was the Perfect Storm Investment Strategy.

So the investors were hooked and came to believe the mantra that stock markets will always continue to rise over the long term. This was likely based on the flawed financial modelling the financial industry use to sell their fund management and their “buy and hold” strategy.

Storm was no different. But their belief in their own marketing pitch meant they appear not to have built in any risk management. They appear to have had no risk management, stop loss or exit strategy and only when much of the wealth was lost did they advise their clients to cash out immediately.

Storm are claiming it was a black swan event that lost their client’s money. I disagree. Nassim Taleb defines a black swan event as follows;

“A black swan is an outlier, an event that lies beyond the realm of normal expectations.”

In my view this was not such an event as it could be predicted because it is known that markets can drop significantly.

If it had fallen 50% in one day I’d agree that would be a black swan. But the market didn’t drop 50% in one or two days. It has taken months for it to lose 50% of its value. Risk controls should have been in place.

The problem was the model used may have accounted for the market falling every 5-7 years but it did not take into account how big a fall might be or how quick the fall would be.

If a large fall occurred over a single day like the 1987 crash then I think a black swan event is applicable. Even if they used a 10-15% stop loss in 1987 the market may well have opened 20-30% down as I believe it did. That would have resulted in significant losses being realised as the stops were activated at the 20-30% loss point.

In this case the market did no such thing. There were plenty of opportunities to exit the market with relatively small losses and much of the capital intact. But Storm advised its clients to do what had worked since 1994 and not sell. In fact I believe they may have encouraged them to take out more margin loans and buy the “dips”. Again this had worked well in the past.

Using margin loans for investing requires tight and disciplined risk management either using stops or other methods to protect against significant losses. Buy and hold won’t cut it when you double your risk using borrowed money because you double your losses in down markets. That’s what kills you.

If the mortgages were doubled up with an equal amount of capital as a margin loan, and the market drops 50% as it has, then the client looses ALL their mortgage money and is left with just the margin loan. I suspect the bank will want the margin loan paid back very quickly.

It seems obvious now but the investors appear to be mostly baby boomers with high equity in their homes. Many appear to be financial naive and ignorant of the financial risks they were taking. Sadly a good marketing story and a twenty year bull market gave them a false sense of security perhaps.

The longer they were invested the more chance there was there would be a market crash at some time. Without good risk management they had no hope of surviving a crash.

The financial planner’s responsibility is to ensure they were aware of these risks and try to minimise them.

However Baby Boomers should never mortgage their homes, double up by margining that loan and invest all that money into what appears to be a single index fund with no risk control or exit strategy.

Financial planners are taught all about risk, client age, leverage, income to loan ratios, risk profiles, diversification and asset allocation to help minimise risk. It’s part of their certification process.

The irony is the Financial Planners Association of Australia has just adopted a voluntary new code of ethics that “puts the client first”. Apparently even now the law only requires a “duty of care” and not for them to be fiduciary responsible with their client’s money.

The new code of ethics is,

“… designed to establish – and planners acknowledge – that they have a fiduciary relationship with clients.”

That’s nice to know. Let’s see how it works out in the future.

Let’s hope these investors can recover some of their money too.

Leave a Reply

CommentLuv badge