Misleading Financial and Investment Illustration

When a broker, insurance agent, or financial planner makes a recommendation with a long time horizon in mind – for example, a recommendation to purchase a variable universal life insurance policy or to choose a particular asset allocation for a retirement portfolio – you likely will be presented with a hypothetical illustration of future performance. But this illustration could be highly misleading and even fraudulent if it does not clearly explain the basis of the assumptions and the possible future downside risks.

How did they come up with this hypothetical projection? What assumptions did they use? And did they illustrate a “worst case scenario” to go along with their rosier visions of future performance?

Investment Return Illustrations

Under FINRA conduct rules the highest annual rate of return that can be shown in an illustration is 12% but the 12% return must be accompanied by a separate illustration showing what would happen to the investment if it grew at 0%. FINRA’s goal is ostensibly to ensure that the customer who sees an illustration of double-digit returns also has some idea of what will happen if the policy or portfolio performs poorly.

But even if the financial professional or insurance agent shows you an illustration with returns calculated at both 0% and 12% annually for some lengthy period in the future, you are receiving a picture that is dangerously distorted and of virtually no value in understanding the likelihood that you will achieve your goals. This is because in the real world, the financial markets don’t provide the same level return each year. Their performance fluctuates, sometimes wildly, from one year to the next, and this volatility renders straight-line projections like “12% per year for 20 years” worthless as a guide to future performance.

A Positive Annual Return for a Loss

In fact, with straight-line “arithmetic” projections, you can actually have a positive annual percentage return in your investments yet end up having lost money. How is this possible? Here’s a simple example. You make a $100,000 investment. In the first year, it grows 80% to $180,000. The next year it drops 50% to $90,000. Based on an arithmetic calculation, your average annual return for these two years is a plus 15% (80% minus 50% = 30% divided by 2 = 15.) But in reality, you’ve lost $10,000 of your original principal over this two-year period. The broker or agent might claim that you got a 15% average annual return, but that won’t help you feel any better about having 10% less money than you started with two years earlier.

Monte Carlo Simulation

There are far better ways to illustrate your likelihood of achieving financial goals. One of these is stochastic testing or, as it’s more commonly called, Monte Carlo simulation. Using a special software program, a professional can run literally thousands of random hypothetical scenarios. He could then tell you, for example, that if you invest X dollars in a certain manner over a certain number of years, the testing showed you achieving or exceeding your target amount just 20% of the time and failing 80% of the time. This range of upsides and downsides gives the investor a far more realistic understanding as to risk. With an 80% chance of failure, most investors would not put their money at risk. It would be a different story, however, if testing showed an 80% likelihood of success.

Misleading illustrations can lead investors to make disastrous choices and suffer devastating losses. Sellers of investment and insurance products have an obligation to provide their customers with information that is fair, balanced, and not misleading. They can be liable for violating this obligation.

If you invested in a financial product based on an illustration that may have been misleading and lost a significant portion of your assets, please contact a financial misconduct attorney at McCarthy, Lebit, Crystal & Liffman today. We will evaluate the facts and may be able to recover your money through the securities arbitration process.

Sales of variable life insurance products are especially prone to abuse involving illustrations. To learn more, please contact our securities fraud lawyers.