It is not uncommon for things to go unnecessarily wrong with investments, and often disastrously so. It is therefore also common for investors to claim that their money was mismanaged and that the broker or bank should pay them damages. The response is frequently that the investor was "experienced," knew what he was getting and wanted it then, so that there is no liability on the part of the seller now. This article will demonstrate that such defenses are all too often invalid and amount to little if anything more than classic victim blaming. (Find out if mutual fund managers can successfully pick stocks or if you're better off with an index fund. See Is Stock Picking A Myth?)
TUTORIAL: Hedge Fund Investing
What Constitutes Real Experience?
Given that banks and brokers are generally extremely keen to evade liability, they will present almost any previous investments as evidence of experience and sophistication. However, such allegations are only valid if the investor probably knew exactly (not just more or less) what he was getting, and furthermore, that the seller delivered exactly what was promised and what was suitable.
This means that there really needs to be a pattern of investor behavior or the repeat of a previous investment. For example, if someone has invested in a certain type of futures contract for several years on execution only, and thus really traded actively himself, he cannot validly claim not to have understood how such assets work in principle, certainly not at the base level. However, if he was sold a dud under false pretenses or there was any mismanagement, that is another matter altogether.
Conversely, consider someone who never had much money before, and had only a few small mutual fund holdings which she never thought about one way or the other. If this person suddenly inherits half a million dollars and gets advised to put it all into some unsuitably risky investment (which earned the seller a packet), these previous fund holdings do not legitimately make her an experienced investor. Furthermore, if the investment was fundamentally unsuitable, either for her circumstances or risk profile, why would she have agreed to it "knowingly and deliberately"?
The Classic Unfair Argument
Abuses of alleged experience exhibit a familiar pattern. They entail a false chain of logic - "he was an experienced investor, so he understood it - he therefore entered into the agreement knowingly and deliberately."
This falsehood generally goes hand in hand with an unfair generalization and extension of anything resembling investment experience, or the mere holding of previous investment, into a full understanding of whatever it was that the investor was advised into that went wrong.
Likewise, general business experience cannot fairly be extrapolated into investment experience. Neither can investment experience in one field be generalized into experience in another. Of course there are rare exceptions.
Furthermore, the issue here is that of real-world investment experience. Academic or theoretical knowledge from books or other media does not constitute genuine experience that provides a defense for the seller. After all, theory and practice are two very different things in any field of activity, and arguably nowhere more so than in the financial field, with its intrinsic conflicts of interest and often enormous information asymmetries. (Big-money sponsorship might make a company look good, but it's not always a reliable gauge of stock quality. Check out Institutional Investors And Fundamentals: What's The Link?)
For the defense to be valid, the case must also depend on the investor knowing or not knowing something very specific.
Only if the investor claims that he did not know a very specific fact and it can be proven that he did know that fact after all, is it a valid defense. Say, for example, the investor claims that he did not know that stop-loss orders do not always work effectively. If it can be proven that he had such controls before, they had failed and he even wrote a letter to the broker complaining about this, then, his claim of ignorance is provably false.
Knowledge of currency fluctuations is another good example of the difference between vague, pretty useless knowledge and very specific real experience that warns you of the true investment risks. Anyone who has studied economics or dealt with foreign currencies knows that the exchange rates can change. However, it is quite another thing to know that currency fluctuations can be extreme and rapid, and can cause you to experience losses or gains greater than those associated with stock market fluctuations. It is the job of the broker to warn you about this and it is not valid to claim, after the losses are there, that you "have used non-dollar currencies before" or "studied (or even taught) economics at the local college," so it's all your fault. This was not your responsibility and that you were aware of the risks certainly cannot be inferred in this manner. Furthermore, most investors do not wish to speculate with exchange rates.
The Losses Must Be Legitimate
If the experienced investor defense is to work, there can also be no misselling, misleading documentation or mismanagement; it must be a perfectly reasonable and suitable investment that went wrong due to legitimate risks that were undoubtedly clear to the investor at the time.
For example, if the investor had a well balanced portfolio with say 40% stocks, and there was a stock market crash, the stock portion could drop by a good 30% or even more. Provided there were no promises of effective loss control and it was clear to the investor that the stock portion of the portfolio would rise and fall roughly with the market, this is a legitimate loss. Again, provided the time horizon is sufficient, the investor should be able to ride out the storm anyway.
However, if the investment was lousy in the first place, the investor obviously did not know this at the time. If the real issue is, for instance, that the portfolio was high risk and undiversified, that must be the focus of the argument, not on the generalized notion that the investor was "sophisticated and experienced," so that he has no rights and the seller no obligations. Brokers and banks have very serious obligations and liabilities that do not disappear at the faintest hint of investment experience.
Discretionary Vs. Execution Only
The legal framework is also important. Both legally and ethically, if the investments were sold specifically "without advice," then the risk lies with the investor. However, if the buyer-seller relationship was advisory and even more so, discretionary, some or all of the liability rests with the seller.
In many damages cases, allegations by the seller that the investor was experienced are nothing more than bad faith attempts to evade liability. Sadly, such "experienced investor" defenses are common, and courts or ombudsmen frequently fall for them.
However, they are only valid in very specific circumstances. If the experienced investor defense is to be legitimate, the case needs to hinge on him having known something very specific at the time of investment, and there has to be equally specific evidence that he did know.
It is essential not to shift the responsibility from where it belongs, onto the victim. Nothing could be further from the valid legal and ethical position, than any form of experience condemning buyers, retrospectively, to the status of an all-purpose "experienced investor" who has no rights. (These big players can both create and destroy value for shareholders. See The Pros And Cons Of Institutional Ownership.)