Types of Investments New Investors Should Avoid
Risk Management Begins With Knowing What Not to Do
If you are new to the world of investing — perhaps you just graduated from medical school or maybe you came into an inheritance from some older relatives — there are several categories of investments that you should consider avoiding until you have a much better mastery of finance, accounting, and business in general. Without the experience and sophistication to be able to parse the good from the bad and the ugly, you are left to the whims of chance; never a place you want to find yourself when your retirement security and standard of living are at risk.
The most important consideration when putting together a collection of assets is making sure that each and every position in the portfolio is sound, conservatively capitalized, and well-managed. Although there will still be unpleasant shocks along the way (such is life), this prudent approach can help minimize the damage caused by such events.
1. Mutual Funds With High Expense Ratios or Sales Loads
The mutual fund expense ratio represents the percentage of your money you have to give to the management company each year. Mutual fund companies such as Vanguard often charge a very reasonable fee between 0.10% and 1.00% per annum, meaning on a $100,000 portfolio, you would pay between $100 per year and $1,000 per year, depending on the specific investment you made. Other mutual fund companies can charge expenses as high as 2.00% (in rare cases, even higher!), meaning that the first $2,000 of your capital gains, dividends, and interest each year would go into the pocket of the asset management company, not you.
It is very difficult getting ahead if you have this kind of expense structure. It's best to avoid it in most cases.
Likewise, a mutual fund sales load is virtually always a bad sign. Run when you see one.
2. Any Type of Derivative, Including Stock Options
I can't tell you how many times new investors, who know next to nothing about the stock market, write me and tell me they are going to speculate with stock options or futures.
These are not the type of thing that anyone without extensive experience should even consider, let alone actually buy. In rare cases, a tiny move of the underlying stock in the short-term can lead to massive losses, even sending you into bankruptcy. Your losses might not be limited to the amount you invest. You could put $10,000 in and find yourself on the hook for $100,000 in debt if you select the wrong transaction under highly leveraged terms.
3. Any Individual Stock For Which You Cannot Answer Several Questions
If you are looking at adding individual stocks to your portfolio, you should be able to quickly explain:
- What the company does
- How the company makes its money
- If the company's pension plan is over or underfunded (if applicable)
- If there is any outstanding dilution
- The debt-to-equity ratio
- The sustainable return on equity
- A reasonable expectation for earnings per share, based on conservative estimates from a detailed business analysis, for 5 and 10 years in the future
- Whether the current earnings yield is reasonable relative the treasury yield and the growth rate
If you can't answer those questions, along with a few others, you are gambling, not investing. You have no business owning individual stocks any more than an inexperienced child should be lighting the pilot of a gas furnace.
Until you are ready, consider a low-cost, diversified index fund. The dumb money almost always wins. Believe it or not, investors are often so bad at managing their own money, that being average is underrated! In fact, despite their long-term appeal, you don't have to invest in stocks build wealth. There are alternatives.
4. Complex Private Entities Designed to Minimize Taxes
It seems that greed almost always makes otherwise smart people do dumb things. Every decade or so, some sort of new entity or security arises that promises huge tax savings in unproven ways. While it might make sense for someone employing a coterie of accountants and lawyers, it's not worth the hassle for someone who is sitting on a very comfortable six-figure or less portfolio. God forbid the IRS disallow the structure, and you find yourself losing most of your capital in penalties and fees!
I've seen people tell their firsthand accounts of it happening, including one man who was driven to bankruptcy. Don't do it. It's not worth the potential pitfalls. Stop trying to be clever.
5. Junk Bonds and Foreign Bonds
I understand that interest rates have been low for the past decade. Too bad. To paraphrase Benjamin Graham, "More money has been lost reaching for an extra point of yield than has been stolen staring down the barrel of a gun." Going from a 4% yield on your bonds to an 8% yield might sound attractive, but not if it comes at an exponentially high increase in default risk. Junk bonds often live up to their name, as the saying goes.
While we're at it, cross foreign bonds off your list, as well.
In the end, it's all about protecting yourself. Making money comes after capital preservation. Otherwise, you can see a lifetime of work wiped out by one or two stupid decisions.