5 Rules to Use to Avoid Bad Investments

Watch out for these major "red flags" which hurt your investment returns.

Stop making bad investments.
Stop and evaluate. It will help you avoid bad investments. Roger Wright /The Image Bank / Getty Images

You can bypass many bad investments by knowing what "catches" to look out for and which clarifying questions to ask. Most bad investment scenarios can be avoided by following five simple rules.

1. Avoid investments with surrender charges

Investments with surrender charges limit flexibility. Some examples are: broker sold annuities and "B" share mutual funds. Investments that have surrender charges have caused problems in all of the following situations:

  • Divorce: Couples invested jointly, only to divorce a few years later. They had two options: pay high surrender charges to get out of their joint investment or stay invested together for six more years.
  • Moving: Suppose you want to buy a new house and need funds to put down until your old house sells? This situation can arise unexpectedly with employment changes. With investments that have surrender charges you cannot access your money without paying what is often a hefty fee. 
  • Health: Health costs for you or loved ones can be expensive. Although some insurance-based investments with surrender charges may offer limited penalty-free access to your money, overall you want full access to your funds when in this situation.

2. Be cautious of investments with limited marketability

Some investment are not easy to get out of. These are called "illiquid". Some examples are real estate partnerships, private placements, private equity investments, and non-publicly traded REITs (or often anything that is called an "alternative" investment).

 If you have too much money in non-liquid investments, you will have no easy access to your funds. Many of these alternative-type investments promise higher returns, but keep in mind you run the risk of losing all or almost all of your investment. Diversify across asset classes and investment sectors and do not put more than 15% of your money in these types of opportunities.

3. Don't make investments which require high upfront commissions or sales loads

Investments that charge upfront commissions can turn out to be bad investments because your advisor has no incentive to provide ongoing service and education to you once the investment is final. Some examples include: "A" share mutual funds, broker sold annuities, and variable universal life (VUL) insurance as an investment.

When you pay an upfront commission, there is literally no additional incentive for the financial advisor to provide ongoing service to you. Keep in mind that today there are many ways to pay for financial advice and many do not involve paying commissions. There can be times where it may make sense to put a small piece of your portfolio into investments that requires a commission or transaction fee, however, it should be minimal.

The exception to this is real estate. A realtor has no ongoing obligation to service your property, so paying a commission on a real estate transaction makes sense. Their job is to find you the right property and negotiate the best deal for you. 

4.  Avoid confusing investments

A good investment can turn into a bad investment when you don't understand how it works.

When you lack understanding or knowledge, you are more likely to make a bad decision based on false trust or emotional rationale.

If it sounds complicated or you just don’t understand the investment, then do one of three things:

  • Ask more questions. (If someone isn’t willing to provide plain English answers, than walk away.)
  • Walk away politely.
  • Hire a professional to evaluate the investment. They should carry Errors and Omissions insurance.

5. Don’t put all your money in the same type of investment

Anyone who recommends you put ALL of your money in any of the following investments is giving you bad investment advice. The list includes, but is not limited to:

  • REIT’s – A REIT, or Real Estate Investment Trust, is like a mutual fund that owns real estate; usually commercial or retail real estate. Some REIT’s are great investments. However, they should only be a small portion of your overall portfolio. 
  • Tax Deferred Accounts – You want to build a balance between tax-deferred accounts (such as IRA or 401(k) accounts) and after-tax money. If all your money is in tax-deferred accounts it can come back to hurt you when you take out significant amounts and the taxes become due.

You can put all your money with:

  • The same reputable mutual fund company, such as Vanguard or Fidelity.
  • The same reputable qualified financial advisor, if they use a diversified portfolio of investments for you.
  • The same brokerage firm, such as Charles Schwab, Fidelity, or TD Ameritrade, as long as your money is diversified across different types of investments inside that account.