An article about choosing safe investments. First published in our client newsletter “The Balanced Report” Spring 1993
This old adage should really be rephrased as "There is a sucker born every minute and two to take him". In our work we are constantly amazed at some of the horrible deals some people get involved with. They most often come to us for advice when it is too late to back out. Our function at that point is only to suggest how they can go about seeking legal redress for their bad investment and to explain the tax deductions they will be entitled to if they have lost their money. Their reaction is somewhat akin to 'Kill the messenger'. But, most respect our opinion and objectivity and will try to make the best of a bad situation with our guidance.
The worst investments seem to come from deals with family and friends. In these cases the normal investigative analysis and scrutinizing that may be required of an arms length deal is often brushed aside due to a blind faith in the other parties judgment or abilities. In some cases the party involved is too embarrassed to ask for collateral or personal guarantees. Many people fail to realize that if their friends could raise the funds they needed at a bank they will usually do so to realize 100% of the profit potential for themselves and not have to share it with anyone. At the bank they will have to give personal guarantees, legal and binding commitments as well as collateral. Why should they object to as much from their friends?
The very worst deals are the loans to our children, especially the ones to help them start a business. In my experience, these types of loans or investments usually have an unsound economic basis and our made out of love. In these cases there is often a great deal of pressure or guilt put on the parents to participate in the venture. The guilt is often self inflicted as most parents feel they could or should have done better for their kids, if only... In these cases any advice on financial grounds has little merit in the decision making process. Our advice in these cases is to see that any money loaned to the children is secured with a promissory note, or second mortgage on their home at 0% interest if necessary and signed by both parties if they are married. As over 50% marriages sadly end in divorce it is only prudent that the funds contributed not be considered as matrimonial properly but a loan to the couple, which must be repaid before a division of the assets.
In appraising an investment the quality of the management is the main consideration. Even in a real estate project where a lot of the value is in land, bricks and mortar, the manager or general partner is still the main consideration. A dishonest manager or poor management can turn sour the best investment in the world. Finding out about the manager is a little tougher and takes some work. Even with mutual fund investing the rule is you move your clients if the manager moves. In other words, if we have a client invested in a particular fund because of the performance or outlook of a particular manager and he leaves we would move our clients to the next fund he has gone to manage. There are of course some exceptions to every rule. But the manager and his experience is the largest single factor in choosing an investment.
In addition there is the issue of 'Are you paying fair market value?' Are the financial projections realistic? Are the assumptions about the market realistic? In a mutual fund the assets are valued every day, so fair market value is known daily, based on the market price of the underlying securities in the portfolio. It does not matter if you are buying or selling everyone gets the same price.
Many people base their investment decisions on which investment did well last year. On Mutual funds, the one that did 30 or 50 percent last year is the one everyone wants to buy. The old rule of 'Buy low ‑ Sell high' is quickly forgotten when people hear those high rates of return. Sad to say, the average person buys high and sells low. Later, they leave the market feeling that it is a rip‑off that is stacked against them. If that same person made the investment decision based on the long-term performance rather than last year, they would be well rewarded in the long term. It takes courage to look at the long term and try to ignore the short-term numbers.
We have been in this business long enough to know that this years' Hero is next years' Dog. Diversification is therefore very important to keep from getting burned. In real estate they have the saying the three rules to successful real estate investing are 'Location, Location, Location'. In the investment business the rule to successful investing is 'Diversification, Diversification, Diversification'. If you or I were to buy stocks for our investment portfolio, we might be able to buy 10 or 15 different companies stocks, below that the transaction costs would be too high and the record keeping cumbersome. In a mutual fund they will have from 50 to 200 different companies in the portfolio. This provides economy of scale as well as lots of diversification. If some of the manager's choices do not do well there will be enough other stocks to soften the impact. This reduces the volatility of the investment. If a small fund or investor makes a big gain on a single stock it has a dramatic impact. In a large fund the big gain is diluted by the size of the fund. Over time the larger fund will do the best and you will sleep a lot better at night, not worrying about the ups and downs of the market.
My mother has a saying that "A fool and his money are soon parted" In our work we see this too often. If you want to lose your money buy lottery tickets or go to Las Vegas. If you want to make your money grow, the above rules are worth remembering.
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www.money-software.com About the Author
Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian Association of Financial Planners for British Columbia, a former Director of the Canadian Association of Financial Planners. He has spoken across Canada on financial planning matters and has taught courses for the Chartered Financial Consultants & Certified Financial Planners degrees. He is the founder of Money Minders Software which produces financial planning software.
