Introduction

When people talk about investments or the stock market, what thoughts come to mind? Do you immediately wonder what tip you might garner from the conversation or presentation, or does your mind jump to the last time you took a chance on an investment, only for it not to live up to your expectations? Maybe you even lost your principal—or several principal investments—and now you’re reluctant to try again.

If you’ve picked up this book, you’re most likely excited about the topic of investment, even if you’ve been burned by past decisions or market downturn. The prospect of hitting it right in the stock market is undeniably appealing for a variety of reasons. Earning money and financial security is probably the number one reason, but being right about something is a close, often subconscious, second.

The stock market, though, is complex. It’s easy to overcomplicate the act of investing to compensate for our nerves and the market’s volatility. Rather than forming a plan and sticking to it, we monitor and adjust, follow the crowd, and react to trends and emotions. We choose to play it safe with conservative investment choices, but it’s impossible to reach our full potential when we never take a chance.

Taking a chance doesn’t mean you have to gamble, or accept a high level of market risk. Despite what many believe, you don’t have to have a degree in finance, a trust fund, the “right” connections, or years of experience to be successful in investing. I certainly had none of these when I started down this road. I did, however, know my answer to what turned out to be a very important question in my career—one that I ask my clients, and that I’m asking you now: do you think it’s possible to invest in the stock market and protect your principal investment?

My Journey

In the summer of 1984, I had just completed my mandatory year of military service with the Yugoslavian army after graduating from high school the prior year. Like many teenagers, I was still trying to figure out my next steps and what the future might hold. The world was harshly divided by western capitalism and eastern socialism, and Yugoslavia—my country at the time—was somewhere in the middle. Private property was permitted, but private business was not.

For a college-bound high school graduate passionate about economics, the social and economic world stage was not ideal. I was determined to follow my interest, but my father had other, smarter ideas. “The world is starting to open up,” he said, “so you need a degree that is recognized throughout the world. Our economics are different than the economics in the west and in the east. Practicing economics, right now, means staying in Yugoslavia your whole life.”

My father made sense. Instead of pursuing economics, my first love, I studied computer science. It was a new field in the early 1980s, and I was good at it. I knew, however, that I would one day follow my early ambition and find a career in economics when the timing was right.

Just three years later, the movie Wall Street was released, and I instantly connected to it. The world of stocks, hedge funds, and investment strategies captivated me. I finished my studies and found a job that allowed me to bridge the fields of computer engineering and economics so that I could make the transition and devote all my energy into what I knew was my destiny.

Years later, my dream came true. I had worked for eight years as an independent consultant when I was offered a position with a major hedge fund as the general manager. Accepting the role without hesitation, I finally felt at home in my career.

The Investor’s Nirvana

I was older than most when I started out in the world of investment. At the time, Merrill Lynch was at the top of their game as an independent wealth management firm. They were strong and respected, and they impressed me because they were pioneers.

In the late 1990s, Merrill Lynch came up with a revolutionary product called Market Index Target-Term Securities® or MITTS®, for short. They were publicly traded securities created for investors seeking capital appreciation and complete principal protection. They allowed investors to maintain a minimum ending value, guaranteeing, at least, the current index value at the end of the fixed MITTS® term, which was often six years. If the initial price of the MITTS® was $10, $7 might go into a zero-coupon bond to guarantee the full value of $10 at maturity. The remaining $3 would then go into a derivative, like S&P futures or stock options.

The return of the index, however, was locked over the life of the MITTS®. If this MITTS® worth $10 reached maturity and the market rose 100 percent, the MITTS® owner earned $20. If the market dropped over the MITTS® lifetime, and the index was lower than where the initial security was issued, the owner was still guaranteed their $10. MITTS® investors locked in 100 percent of the index increase, but 0 percent of the downside market risk.

MITTS® were not stocks or mutual funds, but rather the debt obligations of Merrill Lynch tied to the value of a particular index. In the early 2000s, Merrill Lynch issued MITTS® on the S&P 500® and Dow Jones for many parts of the market. There were MITTS® for almost anything, from foreign stocks and the oil and gas industry, to semiconductors and healthcare. There were small caps and large caps. It seemed the options were endless. And anyone, at any level of experience, could use MITTS® to invest in the stock market. From amateur investors who didn’t want to lose their precious first investment principal, to skilled investors who had played the stock market for years, all could equally benefit from MITTS®.

This was a foolproof solution I stumbled on early in my career, after studying the investment theories of world-renowned financial analyst Dr. Steve Sjuggerud, then the Investment Director at The Oxford Club, one of the most successful and longest-running financial newsletters in the business. It was more than just a solution, though—this was the investor’s Nirvana. I was amazed at both its success and obscurity. Few investors—including professionals—knew of MITTS® or understood how they functioned. As a beginner, I thought I had to be missing some major catch or caveat.

At the time, the internet was in its infancy, so discussion groups and public forums were limited. Even after talking to more experienced professionals and asking coworkers and friends in the industry, I found very few who knew about MITTS® or were utilizing them.

I started small and tested this principal-protected plan from Merrill Lynch that Sjuggerud endorsed. I noticed that MITTS® traded like stocks, but they were not liquid in price, often varying in their true value.

The question lingered: what was the catch?

It turned out there were several catches. The first was that MITTS®, as the debt obligations of Merrill Lynch, were susceptible to their credit risk. If Merrill Lynch’s credit rating worsened, MITTS® and the investors who used them shared the fate of the company. As long as Merrill Lynch stayed a healthy, thriving business, MITTS® investors had nothing to worry about—any serious downfall, however, would put their investment in jeopardy.

The second catch was that MITTS®, with a length of six years, had an issuance date and maturity date, but lacked a customizable exit point that could be tailored to an investor’s preference. Investors had no power over their investment in that six-year period. At the maturity date, the investment paid any increase in the value of the index, plus the principal. If there was no increase in the market value, only the principal was returned. Investors might get lucky and their six-year term would end with a high-index value, but their term could just as easily end at a down point. Regardless, they were in fate’s hands, with limited options.

The final catch was that in the high-interest rate world of the early 2000s, it was easy to protect your principal by creating a synthetic position. MITTS® were constructed with options and bonds, so when investors paid $10 to Merrill Lynch, for example, $7 went to buy a government bond that matured in six years and the remaining $3 were used to buy options on the index. With the high interest rates of the time, the bond would easily reach the full ten-dollar value at the time of maturity. As interest rates fell, however, $3 was no longer enough to buy options.

When the financial crisis hit in 2008, these three issues suddenly became a big deal. Merrill Lynch, seemingly indestructible just a few years earlier, experienced the type of serious downfall that impacted both their credit and their investors. If they had not been acquired by Bank of America in early 2009, MITTS® holders would have been fighting to recuperate a fraction of their investment in bankruptcy court. With Bank of America’s ownership, all MITTS® sold by the original Merrill Lynch were all paid back in full, principal and all.

Create Your Own Destiny

Any type of downswing...