10 Signs Your Client Is About to Make a Bad Investment

When it comes to investing, it’s the Wild West out there. 

Consumers, especially those who are less experienced, are constantly bombarded with so-called opportunities to make a bundle. We’re not talking about outright fraud, but rather perfectly legal sales pitches. It’s not only new investors who fall prey; sophisticated, accredited investors do so as well. 

Here are 10 of the most common mistakes we see from investors of all types:

1. Promises of Unusually High “Guaranteed Returns.” Someone recently approached me to share that his friend just bought an investment that gives him the higher of the stock market return or 9% annually. Now, if there were such an investment, gobs of money would be pouring in (including mine). Often these are sales pitches for insurance products, like variable annuities. The guaranteed return comes from annuitizing the product by paying a far-below-market rate. In addition, they often include the return of principal in that calculation.
2. Pressure to Decide Quickly (“Limited Time Offer”). The late Nobel Prize winner Daniel Kahneman explained human decision-making through two systems: System 1 (fast, intuitive, emotional) and System 2 (slow, deliberate, logical). The limited time offer is designed to get you to think with the former. In other words, they want you to act with your emotions rather than using logic. Worse yet, you may talk to friends, or use the internet or AI, to check out the product if they gave you enough time.
3. Complexity Designed to Confuse, Not Inform. If the investment comes with a 372-page disclosure document, (I can already tell you) it’s a bad investment. Do you think the lawyers and actuaries wrote the document to protect you or the company and its sales reps? It turns out that good investments tend to be simple and easy to understand, like a total stock market index fund.
4. High Expenses. It turns out that fees compound just like returns, though not in the investor’s favor. Granted, the return matters more than fees, but, spoiler alert, investments with high fees tend to have lower returns. They are much better for the company selling the investment than for the investor.
5. Lack of Liquidity. Remember the TV commercials for a Black Flag roach killer, also known as the Roach Motel, that assured the consumer roaches would find it “easy to check in but they can’t check out?” Though there are rarely parallels between pesticides and investment funds, this is one. (I’ve had several clients in funds charging over 10% annual fees with gated redemptions.) In other words, they can’t check out of that motel and get their money back. 

Some products accurately disclose it with surrender schedules, while others hide it somewhere in that 372-page disclosure. Today, some very sophisticated investors thought they were investing in safe private credit funds with promised liquidity only to find most of their money trapped. These semi-liquid products generally stay liquid until performance is poor and investors want their money back. 

6. Leverage Used to Juice Returns. Leverage is good as long as you are on the right side of things. According to Morningstar, nearly half of US leveraged ETFs and exchange-traded notes have closed, and 13% of all leveraged ETPs have returned negative 98% or worse since inception. Some private funds charge a percentage of assets. For instance, if a real estate fund uses 80% leverage, then the 2% fee on assets becomes a 10% fee on that investor equity.  
7. Back-Tested or Hypothetical Returns. It’s much easier to predict the past than the future. Many investments are presented showing what the return would have been had clients actually bought the product or invested in the strategy. Then the product sponsors use academia to support why it outperformed and will continue to do so. 
8. Buying Because Everyone Else Is. Recency bias and FOMO (fear of missing out) are reliable enemies of good investing. Like heat-seeking missiles, we lock into what has worked well in the past and what our neighbor brags about. That’s called following the herd, and it typically doesn’t work out so well.
9. Not Understanding How the Sponsor Makes Money. Let’s revisit the first warning sign and the product guaranteed to earn the higher of the market return or 9% annually. Reverse engineer it: How can the product provider pay a commission, cover their costs, make a profit and still give that wonderful return? The answer is simple: They can’t.
10. Client Can’t Name 3 Things That Could Go Wrong. Nothing is a sure thing, even if the promised return isn’t spectacular. A sign that the investor is using emotional System 1 thinking is that they can’t think of much that can go wrong. They aren’t engaging their System 2 brain. 

Even Treasury Inflation Protected Securities (which I consider the safest investment on the planet) have risks. A TIPS ladder can produce a 2.6% real inflation-adjusted yield, yet things can go wrong. Some examples are: 1) the government can change the way inflation is measured, 2) it can change TIPS taxation, and 3) our national debt that is approaching $40 trillion keeps on climbing, so it’s not completely risk-free. 

Being Irrational Beings. We are not logical, rational beings. We are emotional animals and often make mistakes. I don’t know anyone who hasn’t made some investing mistakes, including yours truly. I’m constantly fighting my emotions and not always sure if I’m thinking with System 1 or 2. 

My advice is to avoid these investing mistakes. They will very likely be hazardous to your wealth.