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7 Warning Signs You Are About to Make a Costly Investing Mistake

Sometimes your biggest investing enemy is in the mirror

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Like everyone, I’ve made my share of investing mistakes. When I review portfolios and talk to clients, I see some recurring themes and warning signs. These typically aren’t fraud, so don’t expect a financial regulator to bail you out. Here are some of the more significant red flags, followed by what you can do to protect yourself.

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1. The promise of high returns and low risk

One investment I recently reviewed claimed to offer “a 7.5 percent+ safe and consistent passive return.” With both stocks and bonds causing pain right now, who wouldn’t want in on that? As much as I certainly would, common sense tells me that if there was such a vehicle, institutions such as pension funds would be clamoring over it so they could invest billions of dollars. They wouldn’t need my money.

Normally, the safer the investment, the lower the return. But there is one exception: A U.S. Government I-Bond, which yields 9.62 percent for the next six months. Its yield is linked to inflation, which is at a 40-year high.

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2. Time is of the essence

You are told some version of: “Unfortunately, this is a limited time offer, as the 10 percent bonus is only good though tomorrow.” What’s happening is that the person selling you this product is trying to get you to think emotionally rather than rationally.

In his book Thinking, Fast and SlowNobel Prize winner Daniel Kahneman describes our two systems of thinking. System 1 is fast, intuitive and emotional; System 2 is slower, more deliberative and more logical. The limited time offer tactic is having you make a decision before your slower but more logical system of thinking has time to kick in. And this tactic isn’t restricted to investing. Advertisements often urge the buyer with wording like “This is a limited time offer and only available while supplies last — act fast before it’s too late.” With investments, go with System 2: Use your deliberative, logical thinking and put your emotions aside.

3. The investment is complex

Better investments are typically simple and easy to understand. Complex investments often come with a thick disclosure document — sometimes hundreds of pages — that you must sign, indicating that you read and fully understood it. I’ve actually never met a financial rep who understood what they were selling, much less a consumer.

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I have at times been asked by a client to read the 173-page disclosure document for something they are considering investing in. I remind them that they don’t need to pay me to read it, as the attorneys and actuaries didn’t write it to protect the buyer. Once you’ve signed the document, it will be much harder to claim you were tricked or that you didn’t understand it.

4. You are investing with conviction

Not too long ago, I was watching a stock-picking TV show where the famous talking head was lecturing that people weren’t investing with conviction. I’m of the opinion that that’s a good thing, because investing with conviction is dangerous. My advice: If you can’t think of at least three things that can go wrong with an investment and how you can lose money, you haven’t thought it through with your logical, System 2 brain.

I have no clue what the stock market will do in the near term or what stocks will outperform, which is why I buy every stock on the planet by using a couple of index funds. Staying the course is important, but always think about what can go wrong and the financial impact it would have on your family if it does.

5. You learn about the investment from a stranger

I get solicitation calls all the time that go something like this: “Hi, this is Rex from Never Miss Drilling Company to let you in on an exclusive offer to invest in our next round of oil wells. We have never had a dry well, and our investors are averaging an 18 percent return for life.” If this were even remotely true, wouldn’t their existing investors be pouring more money in? Why would this company be paying people to cold-call? When it comes to investing, it’s never a good idea to depend upon the kindness of strangers; they don’t usually call to make you rich.

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6. You buy it based on an advertisement

Whether it’s a TV, radio, print or internet-based advertisement, be especially cautious. If a company is spending a lot of money to solicit you, you’re ultimately the one paying for it if you buy. Better investments typically go fast and don’t need to pay to advertise. Be especially wary of infomercials on TV, radio or internet podcasts. These are like talk shows claiming their goal is to educate you. Many financial retirement shows are actually paid infomercials. There may be a very brief disclosure that the company pitching its products paid for the spot; perhaps it’s very brief because they’re hoping you’ll miss it. As intended, these advertisements typically appeal to emotions.

7. It feels good

Though I tell people that investing should be dull if you’re doing it right, sometimes it should be painful. What it should never be is something that feels good. Ignoring any of the above warning signs and handing over your money feels good initially. Getting out of stocks in a bear market to stop future losses feels good as well, though logically it’s selling after a plunge — another investing mistake. Rebalancing your portfolio in a bear market means buying more stocks. Yes, doing so is excruciatingly painful, but logically, it’s buying stocks on sale.

How to protect yourself

First, when considering an investment, don’t plunk down your money immediately. I suspect that limited time offer will still be there in a few days. List things that can go wrong and what impact that would have on your family. Ask how the person and the company offering you the investment is making money and why it can be attractive to you as well.

Do an internet search on the product or company and see what others are saying. I often tell people to go to the Bogleheads online forum and use the search box to see what others think. These searches take only a few minutes, and it is time very well spent.

Go to someone you respect but who doesn’t always agree with you. That could be a spouse, friend or coworker, but not someone who could financially benefit if you buy something from them instead. You want someone who is as impartial as possible. Ask them what they think and whether they would make this move if they were in a similar circumstance as you.

Investing is simple, but never easy. Though there are occasional exceptions, if something looks too good to be true, it probably is.

Allan Roth is a practicing financial planner who has taught finance and behavioral finance at three universities and has written for national publications including The Wall Street Journal. Despite his many credentials (CFP, CPA, MBA), he remains confident that he can still keep investing simple.

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