Last week, I listed six red flags to watch out for when dealing with a financial advisor or broker. To recap, they were:
- Invoking a dead relative in an effort to keep your account
- Recommending variable annuities when they're not appropriate -- such as in an IRA
- Recommending you move money out of your 401(k) or stop contributing. Also: recommending that you borrow from your 401(k)
- Constructing a portfolio for you with an expected annual return of less than 10%
- Recommending only mutual funds, especially those that are only available through his/her company
- Accepting a commission from products they sell
The post was getting long, so I stopped there. This week, I'd like to continue where we left off with more red flags, some of which were suggested by readers like you. Again, these are in no particular order.
7. Suggesting that you borrow from your home equity to invest
I am not an advocate of taking a loan for the specific purpose of investing. This includes taking out a home equity loan to play the arbitrage game many salesmen are suggesting these days.
An arbitrage is when you try to take advantage of a price or interest rate differential between two markets. For example, you take out a home equity loan at, say, 6 percent and invest the money in a mutual fund with an expected return of 10 percent. If successful, you would profit from the 4 percent spread between the loan and the mutual fund.
Salesmen will claim that this strategy is low-risk or even risk-free, but it isn't. What happens if the mutual fund doesn't return 10 percent? What if it returns only 5 percent? Or if it loses money? Compound interest works against you and you stand to lose a lot more than you bargained for.
Also, you can't forget about the fees, commissions and taxes involved in such a strategy. Even if there's a positive spread, these can severely cut into your returns. For me, it doesn't seem worth it.
8. Assuring you that an investment cannot lose money.
An employee of mine showed me a postcard she received from a financial advisor near her neighborhood. He advertised a historical annual return of almost 15 percent with "no known history of loss." The implication is that he can deliver high returns with no risk. Sounds like the perfect investment, right?
RED FLAG! There is no such thing as a risk-free return above what is guaranteed by the U.S. government. It's a basic principle of economics: reward is the profit for risk. As an investor, your job is to manage the trade-offs between risk and reward. A risk-free investment such as a bond will give you about 4-5 percent. If you want more than that -- and most of us do -- you have to be willing to take on a little more risk.
9. Claiming he/she can turn a small amount into a large amount
I heard an advisor on the radio the other day claim he could get his clients a 500 percent return with very little risk. He suggested that he could get that return through a combination of techniques, including investing in real estate.
Is he saying that real estate is low risk? Millions of homeowners, particularly along the West Coast, would disagree! Since the recent housing bubble burst, home prices across the country have been declining steadily. In the top 10 metropolitan areas, home prices declined more than 13 percent since last year, according to the Case-Shiller Home Price Index. Different markets are performing differently, but nowhere are prices ratcheting higher right now. Common sense tells me this claim of a risk-free 500 percent return is simply bogus.
Another financial advisor-type is claiming that he can show you how to turn $10,000 into $3 million in just a couple of years and that he has a 30-year track record to prove it. I did a little math… if he started with $10,000 30 years ago and did what he says, he'd have billions of dollars by now. I haven't seen his name on the Forbes list of the world's richest people, so something tells me his claim doesn't hold water, either.
When someone makes outrageous claims like these, they're playing to your greed. Just remember that with higher returns comes much bigger risk, and if it sounds too good to be true, it probably is.
10. Claiming he/she can successfully and consistently time the market.
Some advisors love to claim that they can tell you when to get out of the market and when to get back in. They'll tell you they have the tools and the research staffs that nobody else has. What they won't tell you is that all the evidence says it can't be done successfully over the long term. Read my recent post on market timers.
11. Attempting to sell you on a fast-moving trend
A former criminal judge told me about numerous schemes that crossed his bench over the years. One of them involved an advisor who sold fractional shares of oil and gas royalties.
"They will lure an investor in with a higher-than-normal return, playing on your greed. Then they come back again several months later and want you to buy more of that share for an even higher return. The house of cards will ultimately fail, leaving the investor with nothing."
A guy called me up not too long ago and offered to sell me fractional shares in something like this, saying that because of rapidly rising energy prices, now is the time to invest. I told him, "If you're calling me, trying to get me to pitch your oil deals to my clients, this tells me that this is the top of the oil rush, not the bottom."
The more people who are calling you and taking out ads regarding a fast-moving trend, it probably means it's time to get out, not get in. To make money, you have to buy when everyone else is irrationally selling and sell when everyone else is irrationally buying. When the sales pitches are fast and furious, alarm bells should go off.
12. Offering you professional services for free.
One reader told me he was suspicious when his CPA offered to do his taxes for free. What kind of a CPA does that? In this reader's case, it was because the accountant wanted him to open an investment account through him. The investment account would probably generate more in commissions and fees than he would charge for doing a tax return.
This isn't necessarily wrong, but it is something to be aware of. Look, people in the financial services business -- or any business, for that matter -- always get paid. None of us does this for free. As a customer, you need to know how they get paid. Would you rather pay them up front and know what you're paying for, or would you rather take your chances with hidden fees and commissions? Look for transparency in pricing.
There are, of course, many more red flags to watch out for. Keep emailing me your suggestions, and I'll keep adding to the list.
1. Glink, Ilyce. "Homeowners react to falling real estate values." The Boston Globe, May 13, 2008 (accessed May 15, 2008).
2. "The World's Billionaires." Forbes, March 5, 2008 (accessed May 15, 2008)
Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.
Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method® Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.