7 simple caution flags in investing

Someone recently asked me "how do I know if my mother should trust her investment advisor?  I've met him and I don't have a good feeling about him at all."

After looking at many investments and dealing with a lot of people over the years, here are a few things to watch out for to stay out of deep water.

1) "It's guaranteed" or "There's no way to lose money"

Nearly all investments have some form of risk.  The only securities considered risk-free are U.S. Treasuries, which is why they typically pay among the lowest of interest rates.  If someone tells you an investment doesn't have risk, or very little risk you need to ask a lot of questions to get to the facts.

2) "Hurry, the deal is closing soon!" 

The term "financial advisor" is a generic title that requires no certification.  Some FA's are really just salespeople.  A common sales technique is to create a deadline to pressure prospective investors into making a decision, much like the "While supplies last!" or "For a limited time only!"sales tactics used to sell stuff on TV.  If you're not comfortable with the investment, you're not going to feel any better after you put your money into it, and by then it'll be too late to get your money back.  Take your time and think carefully about it.  Impatience is a dangerous emotion in investing.

3) Name dropping

A salesperson might say something like "the CEO of XYZ Corp is investing in this too," implying that it's smart for you to make this investment, too.  Just because the CEO bought it doesn't automatically make it a good investment, and he or she may have a risk profile very different from yours.  Instead, ask the salesperson how much of their own personal money they're investing in it.

4) "I'm a Christian - you can trust me"

I saw something on 20/20 or 60 Minutes years ago where they bought a car from a fly-by-night dealer on hidden camera.  They salesman said "I'm a Christian - you can trust me."  Trust is earned over time, not granted during the sale.  Overtly using religion explicitly to make a sale is morally wrong.

5) Sketchy answers to simple questions

I had new client tell me they never got a straight answer when they asked their previous advisor why their account value went down dramatically the month after they started investing, even though the market was up.  I read the prospectus on their investments and discovered their previous advisor didn't want to tell them he made a nice big commission on their sale.

When you ask a simple question, especially about fees and compensation, you should get a straightforward answer with data to back it up.

6) No independent custodian

The safest way to avoid getting scammed is to make sure your investment advisor uses an independent custodian.  Fraud is most often committed when the investment manager is both the custodian (holding the funds) and the investment manager.  This is how Bernie Madoff and other investment managers, accountants and lawyers have duped investors for years - they fabricate their numbers and there isn't a way to verify the dollars.  We use independent custodians such as Schwab Institutional, who is in the business of holding and reporting client funds so you get a built-in check and balance.

7) Incorrect or misleading performance calculations

I once saw an investment proposal given to one of our clients where the math was just plain wrong.  Here's what their numbers showed:

$1,000 investment

$  400 profit

$1,400 Total

140% return on investment

That's not a 140% return it's only a 40% return!

This investment, along with many others from the same manager, eventually went belly-up.  It's tough to stay in business if you don't even know how to calculate a return on investment (ROI)!

Protecting your wealth

By watching out for these seven caution flags you'll help protect yourself from incompetent or dishonest people.