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Updated Sunday, December 23, 2012 at 10:42 AM

How to spot a bad investment

By Chuck Jaffe
Syndicated columnist

The question I was asked most in nearly a decade of writing about stupid investments was what someone needed to do to be a smart investor.

I can answer that question for average investors in three sentences, totaling just eight words:

• Know yourself.

• Understand what you’re buying.

• Be careful.

The second most asked question is much tougher, because it is about the telltale signs and warnings that most commonly signal a stupid investment.

Since early in 2003, my Stupid Investment of the Week (SIOTW) column has examined the conditions and characteristics that cause average investors to make decisions that are “less than ideal.” Since no one sets out to make poor choices and buy something lousy, there always had to be a case for buying something that had equal potential to go wrong.

Today, as the Stupid Investment of the Week column comes to its end — it has been appearing online at seattletimes.com — it is important to revisit the danger signs that are a permanent legacy of bad ideas. (Jaffe’s weekly Mutual Fund column will continue to run.)

It’s important to root out bad investment ideas before they wind up in your investment portfolio.

To do that, examine every investment with an eye toward the following:

High costs

The harder it is to make money after you pay the freight, the more likely you’ve got a poor investment choice. That’s not to say some mutual funds, insurance policies and other securities can’t overcome costs, but most don’t.

Even when an investment has beaten the odds and delivered despite high costs, a buyer should be asking if that can continue, because expenses almost always come home to roost.

Moreover, costs oftentimes are hidden or buried in complex investment products. Investors need to recognize that there is no free lunch; one way or another — whether it is out in the open or buried in the details — you’re the one paying the costs, and no one would be selling it to you if they couldn’t make something on the deal.

Bad timing

This is not so much about engaging in market timing as it is being aware of where an investment really is at the moment you buy it.

A key part of the SIOTW methodology was looking for investments where there was a case to buy, but the very real potential for a security to take a dive before it reached its potential.

Studies show that investors typically bail out if an investment declines more than 20 percent from their buying point; even if a stock takes off from there, all the investor experiences is the loss.

Too often, investors look at the positives without recognizing the factors that could delay the success they foresee. For example, investors may love the concept behind a popular business but may not recognize that short-sellers are swarming the stock, a condition that average investors typically would want to avoid, or they look at a stock that has fallen into bargain territory without considering what might drive the price down further before it can rebound.

Even if your investment premise looks right for the long term, it’s important to recognize the detours that could crop up on the path to success, or you might not complete the journey.

Mass-market appeal

It’s not that appealing to a wide audience is bad, it’s that it may be much easier to get a better deal by putting just a little bit of effort into it.

For example, most insurance policies that you see pitched on television — the ones that promise coverage with no questions asked — are priced as if the buyer already has one foot in the grave.

If you are otherwise uninsurable, that might be OK, but the vast majority of people buying these policies could get more coverage, pay lower premiums or both simply be not jumping in with the crowd.

While there are times to run with the herd, it’s important not to follow along with them mindlessly.

Evasive spin

If you want to know whether you are being sold the equivalent of financial swamp land, be sure to ask about dry basements or resale value.

If the answer — whether from the sellers or the people already in the neighborhood — comes back “Look at the lovely kitchen” or “Only someone with a loser’s attitude would ask that,” run away.

If you ask enough questions and the responses are nervous, worried or hyperaggressive, there’s trouble. If everything doesn’t add up in your head, you deserve answers to your specific questions.

When the people supporting an investment aren’t giving you straight talk, they’re hiding something; no matter what it is, you’re not going to like it.

A never-give-up sales pitch

The very first Stupid Investment of the Week was investment notes from American Business Financial Services, and those clowns continued to send invitations to invest every few weeks, right up until the firm filed for bankruptcy protection and suspended sales and redemptions for investors.

Questionable practices

Sometimes, an investment stinks just because of how it is constructed, the style of management or the ethics of executives. It may be a great marketing idea that’s a poor investment concept.

These flaws aren’t always evident at surface level, but when uncovered can quickly turn an investment that looks good into an ugly situation.


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