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Want to make what you think is a smart investment decision, and lose your life savings? I can show you how.
After 18 years in the investment industry, I've watched people lose money in almost every way imaginable. The most devastating losses are what I call Code Red losses; the kind you can't recover from.
Code Red losses can be avoided. It takes a little knowledge — and a lot of common sense. Eight of the 10 investment decisions below are Code Red mistakes; two aren't.
Read on to learn how to recognize a Code Red investment decision:
1. Believe in a stock
The company you work for is doing well. You understand the potential of the business. You should own a lot of company stock. After all, it shows your level of commitment, right?
For several years I worked in a CPA firm that had a lot of clients who worked for Intel. One of the Intel executives owned 150,000 shares of Intel. At the time Intel was trading at about $73 a share. This persona had $11 million — the majority of their wealth — in a single stock. Although some of it was restricted stock, the majority of the shares could be sold at any time.
We had numerous discussions about the risk of holding so much wealth in a single stock. To our dismay, our advice fell on deaf ears. Feeling helpless, we watched Intel go down, and down. For the last year it has been trading in the low to mid 20s. At $22 a share the same 150,000 shares are worth $3.3 million. Three million is still a decent sum of money, but it won't deliver the standard of living that $11 million will.
You can lock in lifestyle by taking risk off the table. If trusted advisers are telling you to reduce risk, listen. You can't take your "belief" in your company stock to the bank. Owning a lot of company stock doesn't demonstrate a commitment to your company; it demonstrates a lack of commitment to your own personal financial planning.
Code red? Yes.
2. Buy an annuity — as an Investment
An annuity is a good investment, right?
An annuity is a contract with an insurance company. Insurance is a risk management tool — not an investment. When you buy an annuity, you are insuring a particular outcome, not making an investment. The key to using an annuity properly is to understand what you are insuring and to know the cost of that insurance. An annuity can be a great risk management tool, but don't confuse that with investing.
Some variable annuities allow you to invest in mutual fund-like accounts within the annuity, but there is an insurance wrapper surrounding the outcome; the insurance wrapper is promising either a particular guaranteed outcome upon your death (death benefit guarantee) or a specific amount of future income you can draw out (a living benefit guarantee).
I've watched too many people buy a variable annuity because they misunderstood how the guarantees worked. Several years after purchase they find out it doesn't quite work the way they thought it did and some erroneously cash out the variable annuity at that point, losing themselves many thousands of dollars.
You should evaluate annuities as a way to secure sustainable income in retirement — but don't buy them for their investment potential. Buy them to insure an outcome.
Code Red? No. You might get locked into a product that wasn't the best option for you, but you're not likely to lose 90% of your net worth with this choice.
3. Get reeled into real estate
Rental real estate is a good way to build wealth with someone else's money, isn't it? I mean, that's what the infomercials say.
In 2007, one of my good friends owned 12 rental properties with a cumulative value of over $3 million; within a few years all but one were lost through short sale or foreclosure. Then a long process of rebuilding wealth began.
This investor is a smart cookie, holding an executive position with a publicly traded company. She went to numerous workshops on real-estate investing. What went wrong?
She violated one of the first rules of real-estate investing: It takes deep pockets. When the economy goes down, renters can move out, leaving you with a mortgage payment and no income available to make these payments. If you don't have the cash flow to cover the mortgage as well as repairs and maintenance, you'll lose the property.
Investing in real estate is a profession in and of itself. With real estate prices on the rise again, don't get reeled in with the lure of easy passive income. It isn't as easy as it looks.
Code Red? Yes.
4. Follow a Tip
An opportunity to double your money is an investment opportunity worth pursuing. It could change your life, right?
Many years ago a well-educated friend of mine began telling me about a stock he had been investigating. It was poised for big things. He had been to the shareholder meetings and reviewed the financial statements. He was convinced within a few years the value would triple. It was a penny stock. I bought in. When the price went down, I bought some more. Today, my thousands invested are worth a few hundred. I still own shares as a reminder to myself of how easy it is to lose money.
Did I make an investment? No, I gambled, and I lost.
In her book, “Quiet,” Susan Cain tells the story of a man who bought GM stock during the market crash, thinking he could double his retirement savings. He felt safe with the investment because he had heard through reputable sources that the government would bail the company out. When the stock continued to go down, he bought some more. When it went down again, he bought more. As it bottomed out he realized he'd invested nearly his entire life savings. He panicked and sold it. Soon thereafter, the stock recovered. His life savings, however, are forever gone.
Tips are great for your waiter or waitress. But where you family's future is concerned, avoid the tips, and stick with a disciplined and diversified approach.
Code Red? Yes.
5. Change lanes — every year
Smart investors watch the market and frequently move money into the latest high performing investment, right?
Early in my career I worked for a company that offered a Science and Technology mutual fund. In 1998 it achieved returns in excess of 90%. One of my clients wanted to move all their money into this fund. They could not understand my reluctance. As a matter of fact they treated me with disdain, as if I was a fool for not encouraging them to pursue 90% returns. I asked them to sign a disclosure form if they wished to proceed.
I had a déjà vu experience in 2005. Nearly every person that came in to see me wanted to put money into real estate. I would tell them, "Each time you say the word 'real estate' I want you to replace it with the word 'technology' and tell me if it still sounds like a good idea."In 2011, gold became the investment fad of choice. Once again, everyone that came to see began asking about gold — just about the time it reached its peak price.
You've probably noticed if you constantly changes lanes on a backed up highway, always trying to inch ahead, you usually end up farther behind. Driving this way isn't effective; investing this way isn't effective either. Pick a disciplined strategy and stick to it. Jumping from investment to investment is only going to slow you down.
Code Red? Yes.
6. Play the currency cards
Experts can deliver higher returns, right? Find someone who knows how to trade, and you'll be set.
In 2007 once of my clients came to meet with me about a month before his retirement date. He told me he wasn't going to need to withdraw his monthly retirement income from his IRA as he had planned.
"Why?" I asked, intrigued.
He said he'd invested $100,000 in a currency trading program that was paying him $5,000 a month. He showed me the checks he was receiving. I got a sick feeling in my stomach. The math didn't add up. At $5,000 a month, that's $60,000 a year, on a $100,000 investment. No one can deliver returns that high. How do you explain this to someone who has checks in their hand?
Within six months this currency trading program was discovered to be a scam and the perpetrators were arrested. I wasn't surprised.
If experts could generate such high returns, why would they need your business? Don't play the currency cards, the expert cards, or fall for any kind of outlandish promises. I've yet to see one of these programs work the way it was marketed.
Code Red? Yes.
7. Follow your ego
Better investments are available to those with more money, right? If you get the opportunity to participate in something exclusive, it is likely to deliver better returns.
One of the most effective investment sales pitches I've seen is the one that appeals to your ego. In 2006 one of my clients left my firm and moved her $4 million to a firm across town. They told her at her account size, she should be participating in exclusive investment opportunities available only to accredited investors. She invested all her money in three exclusive investments they offered — and lost it all.
The recommendations made to her were grossly inappropriate. She was a widow with four daughters under the age of 21. But the firm she moved to was of the same religion as she, and told her they could handle everything — all her accounting, legal work and investing — so she trusted them. The regulators are investigating, which is good, but they won't be able to get her money back.
If someone appeals to your ego, walk away. When it comes to investing, the only thing I've seen egos do is help someone lose money.
Code Red? Yes.
8. Follow their ego
You can trust prestigious people in your community. That's why you should do business with them, right?
Checks and balances are good in government and in investing. One way to make sure checks and balances are in place is to work with an investment adviser that uses a third party custodian. The third party custodian sends account statements directly to you. The investment adviser can make changes in your account, but the transactions are reported to you directly by the custodian, who isn't and should not be affiliated with the investment adviser.
In fraud cases like the Bernie Madoff situation, his firm served as its own custodian which meant they could make up what their clients would see on their statements. Not good.
If there are no checks and balances in place, don't take the risk. It isn't worth your life savings.
Code Red? Yes.
9. Leverage up
Borrowing at low interest rates and investing in high growth assets is an excellent way to accumulate wealth, isn't it?
About 10 years ago one of my clients shared his plan to build a $5 million home on a lot he owned on the coast in California. To complete the project he would need a construction loan, the use of most of his liquid assets, and a loan against a portfolio he held at another financial institution. I projected the potential results and said, "This only works if everything goes right." Nevertheless, he felt confident and moved forward.
Soon after the home was completed, his employment contract was abruptly terminated. About that time the real estate market and stock market both tanked. Since he had a loan against a portfolio of stocks he received a margin call (which means you must deposit funds). As things stand today his assets are gone and he must rebuild from scratch.
Think twice before borrowing to invest. It causes ruin more often than it causes riches.
Code Red? Yes.
10. Mistaken motives
People marketing investments and financial advice are highly regulated and must give you advice that is in your best interest, right?
About five years ago some friends of mine asked to meet with me to potentially hire me as their financial adviser. They also met with another adviser they knew. I explained to them that I was a fee-only adviser which meant I could not be compensated by commissions in any way and that I had a fiduciary duty to give them advice that was in their best interest. I took the time to explain how index funds work and ran a projection for them using what I deemed to be realistic returns in the 6%-7% range. They hired the other adviser.
Three months later I received a panicked call from them. They told me their adviser they needed about $150,000 to remain liquid as they were shopping for a new home. However, he had invested their entire portfolio — over $1 million — in illiquid investments; two annuities and one privately traded REIT (real-estate investment trust). All were products that paid large commissions to the adviser who sold them. I asked for all their documentation and was able to get them out of the annuities on a technicality.
After solving their problem, I asked them why they hired the other person. They said it was because he said 12% returns were realistic, while I said to expect only 6%-7%. They remain my clients today.
Although you can't learn the entire investment industry, you can always ask for details about compensation. Follow the money and it will tell you a lot about the motive. Commission products have appropriate uses and there are some great advisers who are compensated via commissions — but if someone is putting your entire life savings in illiquid high-commissioned products, you ought to be looking for a new adviser.
Code Red? No, but someone with mistaken motives can still cost you a lot of time and money.