We’ve all been told over and over, by a variety of sources, where to put our money. In fact, most everyone can mention a time when they were tempted to invest in a “sure thing” or a “great deal.” But advice on when not to invest is often a lot less forthcoming. Few people come banging down your door with warnings about products you should not invest in. So, here are a few tips to follow, which may help you to avoid some of the pitfalls of investing in a bad idea.
Understand What You're Investing In
Many investment ideas can sound promising at first. But if you don’t really understand the product and what you are investing in, your great idea can turn into a bad idea very quickly. That’s why it’s important to ask a lot of questions before you invest. In fact, if you need to imbed that warnings into your brain, just talk to an investor who thought investing in mortgage-backed securities (MBS) was a good idea, before the collapse of the real estate market back in 2007. These securities offered high interest rates and were often rated investment grade. But the problem was that few people understand what they really were made of. If more money managers had taken the time to look under the hood of these bonds, they would have seen a bunch of very risky mortgage investments that turned out to be toxic. The moral of the story was and still is, know what you are investing in. And if after asking many questions, you still don’t understand how the product works, chances are you should stay away from it.
(For more, see: The Risks of Mortgage-Backed Securities.)
Can’t Easily Sell? Then Stay Away
Investing for the long-term is generally a good idea. For instance, staying in the stock market throughout its highs and lows can often be very beneficial in the long run. In fact, it’s often not a good idea to exist the market every time there is some volatility. But you do want to have the option of exiting if and when you want to. That’s why you should steer clear of investments that keep your money tied up for months or years. No one has a crystal ball, and if you can’t get access to your money when you need or want it, or when the investment is really heading south, you could lose a lot of money. So find out about any restrictions on exiting a fund before you decide to park your money there. You don’t want a fund that denies you access to your money when you need it most.
Get a Clear Picture of the Risks
Often the potential rewards of an investment seem clearly outlined, but the risks, less so. That is why you need to do your homework. The truth is that understanding the risks involved in putting your money in a particular investment can be equally as important as understanding the rewards you may achieve. We all like to hear about how much money we stand to gain form an investment, but you also want to understand how much you can lose. (For more, see: Are Your Investments Taking on Unnecessary Risk?)
Complex Doesn’t Mean Profitable
Often investors get tricked into thinking that because an investment product is complex, it will likely be profitable, as only experienced investors can understand how it works. But this is not the case. A simple investment strategy can add a lot of profit to a portfolio. Just look at rise of the stock market over the past few years, and you will see evidence of how simple investments can be extremely profitable in the end, and often cost less in fees than a complex one.
Key Words to Be Aware of
Some investments come with wording in their literature that should immediately raise some red flags. For instance, if the prospectus of an investment product includes the language, “proprietary” or “private” you should be sure to read further before deciding to invest. Often these types of investments come with high fees or can be highly illiquid. You may end up spending more money getting into the investment or paying the fees attached to it than you will make on up the upside. In fact, it’s often best to steer clear of investments that use flourish-y language to describe an investment and how it works. Simple, clear language is always better. (For more, see: Understanding Financial Liquidity.)
Avoid High Commissions, Fees
There are many middlemen in the world of investing. They get paid to get you to buy and sell products—and they take a cut in the process. So there is little incentive for these brokers or advisors to advise you against making a buy or a sale. That’s why it’s important to ask around and get other opinions before pouring your money into an investment product that may not be a good idea for you, but is a good deal for the person who is convincing you to invest in it. Of course, some form of commission or fees will exist when you buy most investment products, but paying too high a commission will only help your broker get rich, rather than you.
An alternative to investing in funds with high fees or using a broker to buy stocks for your account is to invest in a low-cost index fund. These funds typically do have a small fee attached, but it is often much less substantial than that of a high cost, actively-managed fund. (For more, see: Why Expense Ratios Are Important to Investors.)
The Bottom Line
Knowing what to invest in is important, but knowing what not to invest in is equally important. If you don’t understand an investment product or the fees or commission to get into it seem exorbitantly high, it’s probably not the right investment choice for you. (For more, see: How to Know When it's Time to Sell a Stock.)