Intelligent people make investment mistakes. As we start a new year, one resolution should be to do our best to avoid these surprisingly common investment errors. It’s important to exercise caution not only with potential investment “opportunities” but also to consider five essential questions to ask yourself before committing to any investment.
First, we explore a few ‘red flags’ to watch out for when investing:
Beware of new investment concepts.
It is tempting to invest early in a new company, a new technology or a new type of investment. We remember the $15,000 investment in Google at its initial public offering, which is now worth $1 million. We forget that Apple almost went bankrupt and needed to accept funding from its archrival, Microsoft.
Innovations excite us while we fear missing out on a once-in-a-lifetime opportunity. Do you remember Theranos? A few years back there was a lot of excitement for a new medical technology that would permit comprehensive blood tests based on a finger prick. Many spoke highly of a young, brilliant entrepreneur named Elizabeth Holmes and took comfort from a Board of Directors of luminaries. As time passed, the scientific realities brought to light that the technology did not work. Investors who rushed in lost money. Those who were willing to wait to see if it worked avoided a loss.
Successful frauds always look legit.
Assessing the competency of an investment manager is as complicated as judging the quality of a doctor or lawyer. We tend to rely on recommendations from people we know as well as factors such as schools attended, accolades awarded, and publicity received. A well-known philanthropist and former stock exchange chairman would have seemed legit, as would have one of the youngest members of Forbes Magazine’s Wealthiest Americans.
One dressed impeccably and worked from luxurious offices in Midtown Manhattan. The other, disheveled and in ill-fitting shorts, looked exactly as we would imagine a brilliant kid re-inventing finance would look like. Neither Bernie Madoff nor Sam Bankman-Fried were legit. You would never have known based on all the accolades each received up until the time they were indicted.
Investments that seem too good to be true, are.
Winning at investing feels great. Research has shown that when we win, whether at sports, a game of chance, or investing, the brain releases dopamine, creating a feeling of pleasure. Like any pleasurable drug, we seek more opportunities to make money. Your Money and Your Brain, a decade old book by Jason Zweig is a must-read for investors.
Investments offering extraordinary returns with little risk do not exist. Why would anyone sell you something of value at a discount rather than keep it? Often the risks are known to the promoter but are not evident to the investor. It is always possible that with luck, a risk does not occur while you own the asset, but relying on luck is gambling, not investing.
Confident, successful people risk being over-confident in assessing investment opportunities.
All too often, success in their profession is assumed to carry over to assessing investment opportunities. Their confidence leads to believing they see investment opportunities where others don’t or that they can assess risk better than professional investors. Confidence is great, but over-confidence leads to poor investment decisions. To generate a return greater than its risks, an investment must be purchased at a price below its fair value and there must be a catalyst which will cause other investors to realize the mispricing and bid up the price faster than the market’s appreciation. Without a catalyst, a cheap stock will remain cheap forever.
Now, let’s consider five questions to ask yourself before investing in someone or something new.
Can I explain to someone how the individual or company makes money, and am I sure they do what they say they do?
Bernie Madoff offered 10% returns with no volatility at a time when legitimate, safe investments yielded 2%.
Why are others not seeing this exceptional investment opportunity that I see?
Financial markets are quite efficient at equating expected returns and risks. If the opportunity looks very attractive to you, take the time to find the hidden risks.
What will be the catalyst for other investors to bid up the price?
Exceptional returns are earned only when the market realizes their error in assessing risk and return.
If I lose most of my investment, what will be the impact on our family’s wealth?
Risky investments should be limited in size to what you can afford to lose.
Is the effort of analyzing and monitoring the investment worth it?
Doing sufficient due diligence takes time. Assuming others did it before they invested is dangerous.
As we begin a new year, it’s crucial for investors to be mindful of common mistakes that can impact their financial well-being. Asking yourself these five questions can shed light on whether an investment is something to consider or too good to be true.