5 Rules to Use to Avoid Bad Investments
Watch out for these major "red flags" which hurt your investment returns
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.
Avoid Investments with Surrender Charges
Some examples Investments that have surrender charges can cause problems in situations such as:
- 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.
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 not have 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.
Avoid 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 require a commission or transaction fee, but 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.
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. If the opportunity 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 then walk away.)
- Walk away politely.
- Hire a professional to evaluate the investment. They should carry Errors and Omissions insurance.
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. While any of the following can be a valuable part of your portfolio, don't put all your money into just one of these:
- Annuities – Annuities can offer guarantees that may be important to you. However, if someone recommends you put all your money, both taxable money and tax-deferred money (such as IRA accounts), into annuities, this is not wise due to high fees and limited liquidity.
- REIT’s – A REIT, or Real Estate Investment Trust, is like a mutual fund that owns 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.
While you don't want all your money in just one kind of investment, you can safely choose a single advisor or firm to handle a range of investments. For example, 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.