5 Rules to Help You Avoid Bad Investments

a financial adviser discusses fees with clients.
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You can bypass many bad investments by knowing what "catches" to look out for and what questions to ask. Follow these five simple rules to avoid most bad investment schemes.

1. Look Out for Surrender Charges

Do you want investments you can get out of for any reason? Annuities sold by brokers and "B" share mutual funds can carry surrender charges, which can limit your ability to get out of them. Surrender charges can cause problems in many events. These events may include:

  • Divorce: Married couples who have joint investments and want to get out of them because of divorce have two options. They can pay high charges to get out of their joint investment or stay invested even though they'll be divorced.
  • Moving: Suppose you want to buy a new house and need funds to put down until your old house sells. This can happen for many reasons, including a job change that requires you to move in a short time span. To access your money, you'll have to pay surrender charges. It's your money, but you can't get your money without paying what is often a hefty fee. 
  • Health: Health care for yourself or your loved ones can be costly. While some insurance investments with surrender charges may offer limited access to your money without paying a fee, you may still want full access to your funds.

2. Watch Out for Investments With Liquidity Limits

Some investments are not as easy to get out of as they were to get into. These are called illiquid assets. Illiquid means that it is a security or asset that does not have much trading volume. Some examples are real estate partnerships, private placements, private equity investments, non-publicly traded REITs, and some "alternative" investments.

If you have too much money in non-liquid investments, you will not have easy access to your funds. Many of them promise higher returns, but keep in mind you may run the risk of losing all or almost all of your money. Diversify across asset classes and sectors, and do not put more than 15% of your money in these risky ventures.

3. Avoid Investments That Need High Upfront Commissions

Investments that charge upfront commissions can turn out to be a bad place to put your money. Your broker has no reason to provide ongoing service and education to you once you've given them your money to invest. "A" share mutual funds, annuities sold by brokers, and variable universal life (VUL) insurance could all include upfront fees.

When you pay fees upfront, there is no added reason for the adviser or broker 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 upfront. There can be times where it may make sense to put a small piece of your portfolio into investments that require a commission fee, but it should be a small part.

This does not hold when it comes to 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 get the best deal for you. 

Financial advisor fees are charged in a number of ways. While they do need to be paid for the service they provide, you need to know how yours is being paid if you choose to use one.

4. Avoid Investments That Don't Make Sense

A good investment can turn into a bad one when you don't know how it works. When it doesn't make sense to you, there's a good chance you may make a bad choice. If the opportunity sounds complex or you just don’t understand it, then do one of three things:

  • Ask more questions. If the person you're dealing with isn’t willing or able to provide clear answers, walk away.
  • Walk away. You don't need to give a reason if it doesn't feel right in your gut.
  • Hire a professional to look at the investment. They should carry errors and omissions (E&O) insurance.

5. Don’t Put All Your Money in the Same Type of Investment

A person who tells you to put all of your money in any of these investments is giving you bad money advice. While any of the items below can be a useful part of your portfolio, don't put all your money into just one of these.

Annuities

Annuities can offer guarantees that may matter to you. Still, if a person tells you to put all your money, both taxable money and tax-deferred money (such as IRA accounts), into annuities, is not giving you good advice. You will end up with high fees and you won't be able to access your money when you want.

REITs

real estate investment trust (REIT) is like a mutual fund that owns commercial or retail real estate. Some REITs are a great place to invest. Still, 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. This will allow you to access emergency funds without creating a massive tax burden. If all your money is in tax-deferred accounts, it can come back to hurt you when you take out large 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 instance, you can put your money into any or all of these:

  • A mutual fund company with solid standing such as Vanguard or Fidelity.
  • qualified financial advisor, if they create a diversified portfolio of investments for you.
  • A brokerage firm, such as Charles Schwab, Fidelity, or TD Ameritrade, as long as your money is spread across different types of investments inside that account.