The market crash of the past decade resulted in a vicious one-two punch for many retail investors. Stung by the massive drops across nearly all asset classes, investors retreated from the market. But equally painful but less reported, is that when publicly traded markets roared back to life (and still continue to do so), many investors never waded back in, or if they did, not until much later in the cycle.
There are several consequences from this. For example, retail investors may fail to take enough risk to meet long-term goals such as retirement. But also, a deep skepticism of public markets may convince investors to consider private investment opportunities to obtain yield.
At a fundamental level, placing money in private investments may well violate a basic principle of investing: identifying who you are. For example, are you a speculator or an investor? And if an investor, are you an active or passive investor? For most people, answering these questions should yield a well-diversified portfolio of stocks and bonds with minimal transaction fees.
However, if you insist on going down a path to invest in something more exotic, it is incumbent upon you to do your homework.
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First and foremost, you must answer a basic question: Are you prepared to lose the entire investment? If the answer is no, don’t invest.
If you are prepared to lose the entire investment, you must then have a clear understanding of what you are investing in. That means understanding the investment, its characteristics and associated risks. For example, if you’re investing in a startup, what is the business plan? What are the hurdles? What are the financial goals and are they realistic? All too often, people rely upon a good story and a shiny brochure or presentation without digging into the facts.
To that end, digging into the facts requires that you find out for yourself if the story being presented to you matches reality.
For almost 20 years, a small businessman in Minnesota named Tom Petters was able to dupe both small local investors and multibillion dollar hedge funds with a narrative that he was brokering the sale of billions of dollars of electronic goods to big box stores. Had any of these investors just reached out to the big box stores to verify this elementary fact, they would have discovered that Petters was not engaged in any meaningful level of business with those stores. No one did so, and investors lost billions.
It is also incumbent that the transaction you’re engaging in be documented properly and that you independently ensure that the investment requirements are complied with. If you’re lending money and being given a mortgage on a piece of real estate, you must check that the mortgage is recorded properly. If your investment requires a party to provide you financial disclosures on a recurring basis, enforce your rights to get this information.
Bottom line: If the transaction is not documented properly, then the investment takes on additional risk that you never negotiated to take on.
Finally, in no other area of life is the maxim “if it sounds too good to be true, then it probably is” more appropriate. At its core, investing involves a positive relationship between risk and reward. The riskier the investment, the higher rate of return you must require to make the investment. If someone is promising you a guaranteed rate of return of 15 percent when similar investments would yield a return of 5 percent, then something is amiss and you should be skeptical.
In the Scott Rothstein fraud, investors handed over hundreds of millions of dollars to a South Florida lawyer with the expectation of making astronomical returns with little to no risk. That investment description defied common sense and, ultimately, it was revealed that Rothstein concocted the largest investment fraud in Florida history.
The time and money required to do independent due diligence and properly monitor the investment can be substantial. These transactional costs can also materially erode the return you expected to make and should again force you to consider whether the investment is worth pursuing versus a passive investment strategy.
In investing, there is no such thing as a free lunch.
Jonathan Feldman is an attorney at Perlman Bajandas, Yevoli & Albright P.L. and focuses his practice on financial services litigation, complex commercial litigation and professional malpractice litigation. Feldman is also a CFA charterholder.
▪ This is part of an occasional series by CFA Society Miami for Business Monday in the Miami Herald. The opinions expressed are those of the writer and do not necessarily reflect those of the newspaper.