Best ways to find bad investments
It's hard to be a savvy investor. More often than not, mutual fund managers -- who pick stocks for a living -- cannot beat their benchmarks.
Being a bad investor, however, is a slam-dunk. All you have to do is listen to the banter of financial intelligentsia.
"The vast majority of the financial media preys on the lack of knowledge and wisdom of individuals," says Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis and author of "Wise Investing Made Simpler" and "The Only Guide You'll Ever Need for the Right Financial Plan."
That remark leads us right to the first rule of bad investing. For fun, Bankrate took a stab at finding financial advice no one should EVER take. Read on to discover the ways you can lose money.
Treat all information as equally relevant
At no point in history have individuals had access to the vast reams of information that currently spin around cyberspace. The problem is sifting out the valuable pieces from the rubbish.
"You turn on (a certain business-oriented TV station) and get all of the noise," says Swedroe. "People who read, read books on what to buy right now, what are the hot funds and those kinds of things instead of the academic research," he says.
For instance, there's a lot of pearl-clutching going on over the debt crisis in Europe. Is it a serious situation? Undoubtedly. Would the failure of Greece make much difference to your investing strategy? Not so much.
"Were you aware that Iceland failed several years ago? Did it impact your portfolio? I guess not," says Robert Fragasso, CFP, chairman and chief executive officer at Fragasso Financial Advisors in Pittsburgh.
Not every bit of news requires action or hand-wringing.
"If we just look at the long-term history of events, we find out that there may be short-term correlation but not medium- or long-term correlation," Fragasso says.
If the price is low, it must be on sale
Everyone wants to get a great deal. That can make cheaply priced stocks seem more appealing than they actually are.
"If the stock is $2 a share, (people) might say, 'Well what do I have to lose?' They don't realize that 99 percent of the time, stocks are $2 a share or less because they deserve to be $2 a share or less," says Bernard R. Wolfe, CFP, founder of Bernard R. Wolfe & Associates in Chevy Chase, Md.
It's important to distinguish between a low-priced stock and one that is undervalued.
"There are stocks that are distressed, not cheap. They are low-priced relative to their book value, relative to their earnings, to sales, to cash flow, relative to the dividends -- so they have a high dividend yield. All of these are metrics in what financial economists call value stocks," Swedroe says.
When companies have a low stock price compared to their earnings for the past year, that can indicate the market believes the company is something of a risk "and therefore has to have high expected returns to compensate for those risks," Swedroe says.
Expect amazing returns from great companies now
Information is power: When you have it, you're in control. When everyone has it, it's not worth that much. Such is the case with the stock of great companies.
"People make the tremendous mistake of thinking that great companies provide high expected returns because they are great companies," Swedroe says.
The problem is everyone knows it's a great company and that is generally reflected in the stock price. When more people want to buy, the price goes up. The only investments that offer massive, outsized returns are the ones that come with commensurate risk.
"The best analogy is that in most sporting events it is often easy to tell which team is going to win the game. You can never be 100 percent sure, but sometimes you can be pretty certain. That is why there are very, very few people who get rich betting on sporting events," Swedroe says.
The same thing is true for bets in the stock market.
Pile on risk despite short time horizons
Even the best stocks can take a tumble. During a person's working years, there's a long period of time to recover from stock market dips. As no one can live forever and few can work until they die, that time horizon shortens as retirement nears.
That's when the rules change a little bit.
"'The market always comes back' is what people say. The problem with that statement is that when I'm in the earning years of my life, if the market goes down or if there is a loss in my investment, I don't get hurt because I'm not living off of it," says Dan Morris, senior partner with the law firm of Morris, Hall and Kinghorn in Phoenix.
Once investors need to dip into their portfolio on a regular basis rather than adding to it, a market downturn can be incredibly painful.
There are many strategies for distributing your life savings over the course of retirement. Having a strategy in place long before the last day of work will mitigate some of the uncertainty of the stock market.
All annuities are the same, right?
Finding a bad annuity is frighteningly easy. But not all annuities are bad. They can be the best solution for some retirees.
"I'm not going to lose the principal and have some guarantee of some interest, and if the market goes up, I can enjoy the benefits of it. But if it goes down, I have a guarantee that I'm not going to lose my investment, and I have a guarantee of some sort of return," says Morris.
"It depends on the annuity though. Annuities are good, bad and horrible. And there is where the adviser that comes into the picture is critically important to the success," he says.
These are some questions to ask an adviser about an annuity, according to Morris.
- What kind of return are you, my adviser, going to receive off of this advice that you give me?
- What are my risks?
- Do I have a long period of time in which I can get out without a horrible penalty?
Annuities can come with hidden fees and complicated structures, which make them difficult for individuals to truly understand. Because advisers often make a mint selling them, it's never a bad idea to get a second opinion from a disinterested third party.