What Is Due Diligence?
Due Diligence Explained
Due diligence ensures that, before you invest in a security or with an advisor, you understand the relevant information about the security or advisor and are reasonably certain that the information you have is accurate.
In this article, we’ll explain due diligence in the context of individual investing choice and suggest how you can perform your own due diligence.
What Is Due Diligence?
Performing due diligence means that, as an investor, you investigate and verify any and all information relevant to an investment decision. Through due diligence, you can determine whether the investment decision is a smart one based on what you know about the opportunity or person.
In order to do that, you need to conduct research. There are several reasons why research benefits you:
- It reveals information you may not have been aware of.
- It helps you find negative indicators that might deter you from a bad investment choice.
- It confirms or refutes information others told you.
- It enables you to determine if the decision is appropriate based on your specific criteria.
How Due Diligence Works
As an individual investor, you may need to perform your own due diligence regarding investments, investment professionals, or both depending on which products and services you use. While you are free to develop your own research methodology, the Securities and Exchange Commission (SEC) recommends getting answers to five specific questions as part of your due diligence.
1. Is the Seller Licensed?
In order to engage with the public for fees or commissions, an investment professional must be properly licensed and registered. You can check an investment professional’s registration status on the Investment Advisor Public Disclosure website, and you can check a broker’s registration through BrokerCheck. An advisor with a “disclosure” indicates a complaint, regulatory action, court cases related to investments, or bankruptcies; any of these could be potential red flags.
2. Is the Investment Registered?
Publicly traded companies must file documents with the SEC that disclose relevant information about their business so that it’s available to interested investors. If you are working with an advisor, they can give you this information, or you can go directly to the SEC’s EDGAR database to retrieve it as well.
3. How Do the Risks Compare With the Potential Rewards?
The tradeoff between risk and reward in investing cannot be ignored. It is important to understand the risks associated with a particular investment. While greater risk means there is a better chance of higher returns, it also means there’s a greater chance of loss, too.
When assessing risk, it’s essential to consider whether you can afford to take the risk (lose your entire investment, for example), how comfortable you are with risk in general, and if the risk required is justified by the amount you’re likely to profit.
4. Do You Understand the Investment?
If investing seems complicated at first, that’s okay. The more you familiarize yourself with the particular investment or investments you’re interested in, the less complicated it should be to you. Read the prospectus and public disclosures for any investment you’re considering and ask a trusted professional for help if you don’t fully understand. If you still aren’t sure how an investment works, it is probably better to choose another opportunity.
5. Where Can You Turn for Help?
Investment industry regulatory agencies such as FINRA, the SEC, and state regulators are available to help if you have questions or concerns about a particular investment or investment professional.
A Practical Example of Due Diligence
To see due diligence in action, it’s helpful to consider an example. Suppose you want to invest in a specific mutual fund or ETF. In order to determine if you should, you apply the SEC’s recommended questions.
If you are purchasing the fund through a broker, check to see that the seller is licensed.
Whether you purchase the fund through a broker or directly with the company, look at the fund’s prospectus for information about its objective, expenses, risks, and management. Weigh this information in the context of your goals and reasons for investing. The prospectus also explains the particular risk that the fund will expose you to and how the fund has performed relative to the appropriate benchmarks.
After you go through the prospectus (and likely do a little outside research), the final question to ask yourself is whether you understand how the fund operates, how you pay for it, and whether it is a good fit for your investment plan. If you don’t understand or feel comfortable with the fund, explore other options.
You can use tools like FINRA’s Fund Analyzer to gain more insight if you feel like you need additional information.
Due Diligence Can Help Identify Possible Fraud
Conducting appropriate due diligence helps you by revealing information about what you are getting involved with, whether it’s a relationship with an investment professional or purchasing a specific investment.
But it’s also a critical step to avoiding fraudulent investments or “professionals” and the catastrophic losses that can result.
For example, infamous Ponzi scheme mastermind Bernie Madoff was sentenced to 150 years in prison for defrauding investors who, according to court documents, lost around $13 billion through Madoff’s demise. While this was an issue of fraud, investors could’ve possibly avoided Madoff with more thorough due diligence.
- It is important to understand and verify the relevant information involved in any investment decision.
- Due diligence is the process of researching and understanding the information relevant to an investment or investment professional to make an informed decision.
- Due diligence can help you avoid bad investment decisions, and helps you make sure you choose investments that align with your risk tolerance and investment objectives.