The Stocks Wall Street Wants You to Own

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Financial innovation has gotten a bad rap lately. Nowadays, when Wall Street brings out a new financial product -- or dresses up an old one -- people automatically figure that financial firms must be looking to dump unwanted stocks on unsuspecting investors.

One investment that has raised exactly that sort of controversy lately is the reverse convertible. Although similar investments have been available to investors for years, the market's free fall over the past year has exposed the weaknesses of reverse convertibles -- and has some people wondering whether Wall Street should be allowed to sell them in the first place.

Why reverse convertibles?
To understand reverse convertibles, it's useful to understand what a regular convertible security is. With a typical convertible security, the owner receives a stream of income, through either interest or dividend payments, for a certain period of time. At some point, the owner has the right to convert the security into a fixed number of shares of the issuer's regular common stock -- or, sometimes, a fixed cash payment.

Owners of regular convertibles ideally want the issuer's stock to jump. Then, they can convert their securities into highly valued stock, which they can then sell for a profit or hold for future gains.

Reverse convertibles work similarly, but with a twist. With reverse convertibles, you get the same higher stream of income, but it's the issuer that has the right to force you to convert if shares drop by more than a certain percentage. That switches the incentives around -- now, the issuer wants the stock price to fall, so that the issuer can force you to take shares that are worth less than what you paid for the reverse convertible in the first place.

Who's selling them?
Reverse convertibles have become quite prevalent lately. Many issuers, including JPMorgan Chase (NYSE: JPM) and Citigroup (NYSE: C), have gotten in on the action. Here's a sampling of recent offerings:

Stock	Pricing Date	Maturity Date	1-Year Return on Underlying Stock
Whole Foods (Nasdaq: WFMI)	June 25, 2009	Dec. 31, 2009	(2.0%)
Home Depot (NYSE: HD)	June 25, 2009	June 30, 2010	(3.4%)
Alcoa (NYSE: AA)	June 25, 2009	Sept. 30, 2009	(72.3%)
PotashCorp (NYSE: POT)	June 12, 2009	Dec. 16, 2009	(62.9%)
Dell (Nasdaq: DELL)	June 12, 2009	June 16, 2010	(44.6%)

Source: Structured Products, Yahoo! Finance.

Investors are attracted to reverse convertibles because of the high interest rates they offer. According to a recent Wall Street Journal article, a sample of several reverse convertibles paid rates between 6% and 13%. However, when stocks fall sharply -- as they did in 2008 -- investors get stuck with big losses on the shares they're forced to take due to the conversion.

A rose by any other name
Sophisticated investors will recognize that the payoff structure of a reverse convertible closely resembles what you get when you write a put option. If the stock stays stable or rises in value, writing a put lets you keep the premium you receive for it, but you don't participate in the upside of the stock. Meanwhile, if the stock falls, you'll have to buy shares for more than they're worth in the market.

The problem, though, is that according to the WSJ, firms are marketing reverse convertibles to investors who aren't sophisticated enough to understand what they're getting into. Issuing banks also get a sizable fee for selling reverse convertibles. Now that past investments in reverse convertibles have gone sour, many investors are filing complaints with regulators to try to recover some of their losses.

Yet, in my view, investors can't claim complete ignorance. By now, after scams like the Madoff Ponzi scheme, no one should believe that they can earn above-market interest on an investment without any added risk.

Know what you own
For the right investor, reverse convertibles could serve a useful purpose for a portfolio. But before you buy any investment that makes promises of high returns, make sure you understand the risks involved. Rest assured, there are some, and the harder you have to dig to find them, the more wary you should be with your money.

For more on how to invest like a pro, read about:

• 4 reasons you should sell a stock.
• 5 traits of great stocks.
• What John Bogle has to say about buy and hold.
• An Investment for All Markets