In my decade of writing about stupid investments, I’ve often been asked this question by readers: “How do I become a smart investor?”
I can answer that question for average investors in three sentences, totaling just eight words: Know yourself. Understand what you’re buying. Be careful.
If you follow those instructions, it’s hard to make big investment mistakes.
The second most common question is tougher to answer, because it concerns what a stupid investment looks like and how to spot one. There’s something of an art to this. Two years ago at a big industry conference, when I told a friend I was hunting for column fodder, he asked how I would find it. I told him I would wander until I smelled it and stop when I stepped in it.
Today, I want to leave you with an enhanced sense of smell.
Since early in 2003, my Stupid Investment of the Week column has examined the conditions and characteristics that lead average investors to choices that are less than ideal. Since no one sets out to make poor decisions and buy something lousy, the idea here typically was to deconstruct the case for purchasing an investment and highlighting its potential for going wrong.
Bad investments -- and the problems that lead to them -- aren’t going anywhere. The investments I’ve examined over the past decade have ranged from good companies that, for a time, were bad stocks to inherently, irrevocably flawed investment products -- and seemingly everything in between. While more than 20% of the investments I've covered are gone now, some live on, and probably will forever, kind of like investment cockroaches, always there to feed on investors who are sloppy in their financial housekeeping. And for every stupid investment that disappeared, at least one new concept or issue has stepped in to fill the void.
While not every bad investment idea comes with a screaming red flag, some characteristics routinely arise that should indicate you’re headed into the danger zone:
High costs
The harder it is to make money after you pay the freight, the more likely you’ve got a poor investment choice. That’s not to say some mutual funds, insurance policies and other securities can’t overcome costs. But most don’t, especially over long periods of time.
Investors must recognize that there is no free lunch; one way or another, you’ll pay the costs -- whether they are out in the open or buried in complex details -- and no one would sell that investment to you if he couldn’t make something on the deal.
Mass-market appeal
It’s not that appealing to a wide audience is bad, but it doesn’t necessarily lead to great investment products, and consumers often can get a better deal just by putting a little individual effort into it.
For example, most insurance policies pitched on television -- the ones that promise coverage with no questions asked -- are priced as if the buyer already has one foot in the grave. If you are otherwise uninsurable, that might be OK, but the vast majority of people buying these policies could get more coverage, pay lower premiums or both simply by not jumping in with the crowd.
While there are times to run with the herd, it’s important not to follow along mindlessly.
Financial rope-a-dope
If you want to know whether you are being sold the equivalent of financial swampland, be sure to ask about dry basements or resale value.
If the answer -- whether from the sellers or the people already in the neighborhood -- comes back, “Look at the lovely kitchen,” or, “Only someone with a loser’s attitude would ask that,” run away.
If you ask enough questions and the responses are hinky, nervous, worried or hyperaggressive, you’ve got trouble. If everything doesn’t add up, keep asking. You deserve answers.
When the people supporting an investment aren’t giving you straight talk, they’re hiding something. No matter what it is, you’re not going to like it.
More from MarketWatch:
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- 10 things mutual fund companies won’t say
Bad timing
This is not so much about engaging in market timing as it is being aware of where an investment really is at the moment you buy it.
A key part of my methodology is looking for investments for which a case can be made to buy, but which also carry the very real possibility of taking a dive before they reach their potential. Studies show that investors typically bail out if an investment declines more than 20% from the buying point; even if a stock takes off from there, all the investor experiences is the loss.
Too often, investors look at positives without recognizing the factors that could delay the success they foresee. For example, investors may love the concept behind a popular business, but may not recognize that short-sellers are swarming the stock, or they may see a stock that has fallen into bargain territory without considering what might drive the price down further before it can rebound.
Investors love the idea of “buy low, sell high,” but have trouble executing it -- and they all too often get it backwards.
Even if your investment premise looks right for the long term, it’s important to recognize the detours that could crop up on the path to success. If you don’t, you may not complete the journey.
A never-give-up sales pitch
My very first Stupid Investment of the Week column focused on investment notes from American Business Financial Services, and that firm continued to send me invitations to invest every few weeks, right up until it filed for bankruptcy protection and suspended sales and redemptions for investors.
Likewise, if you request information on the Gerber Life Grow-Up Plan (a lousy life insurance policy for children) or the AARP Guaranteed Acceptance Life Insurance plan (a bad idea for grown-ups), you may be in for receiving mailers until your loved ones are collecting on your life insurance.
Irrational exuberance
This is an extension of bad timing, with more emotion factored in. All too often, average investors find out about an investment only after it has come into vogue, by which time it may be ready to hit the skids. It’s important to remember -- and consider -- that every investment can go wrong, even the ones that appear to be can’t-miss opportunities.
Poor governance, questionable premises
Sometimes, an investment stinks just because of how it is constructed, the style of management or the ethics of the company’s executives. It may be a great marketing idea but a poor investment concept.
These flaws aren’t always immediately evident, but when they surface, they can quickly turn an attractive investment into an ugly situation.
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