Avoiding bad investments is the first step in the creation of wealth. It can take years for a portfolio to recover from a few investments that could have been avoided in the first place. Fortunately, there are several investment warning signs and red flags to help you spot the investment products and stocks you should avoid.
Why you should avoid bad investments
A good investment might generate returns of 15 to 20% a year. Unfortunately, bad investments can lose far more than that very quickly. So even if you get your market timing right on most of your investments, a few bad apples can erase all those gains. Good investing involves smart asset allocation, managing portfolio risk and patience.
Certain types of investments should be avoided regardless of your risk tolerance. They just aren’t worth the risk because, besides losing money, they will create stress and you will end up wasting time on them. Therefore, you should be on the lookout for obvious investment warning signs.
15 Investment warning signs
- Promises of high returns
- Moving the goal posts
- Delayed redemptions
- No third party involved in administration of assets
- Lack of liquidity
- Dividend cut
- Delayed release of results
- Changes in accounting policies
- Executive turnover
- Insider selling
- Rising high debt
- Low ROE
- Valuation very low
The following five red flags apply to advisors, funds and investment products.
1. Promises of high returns
The most common of all investment warning signs is the promise of returns that are too good to be true. In fact, promising returns that are any higher than bond yields or current interest rates is a red flag. High pressure sales tactics or promises of returns that will make you rich are a sure sign of an investment scam.
All investments carry some level of risk – which means you may lose some money. That means returns cannot be guaranteed or promised. Only a government can guarantee returns and there are even limits to that. Legitimate asset management companies explain their investment strategies and may have a benchmark that they aim to beat. One of the reasons ETF investing has become so popular is that exchange traded funds aim simply to earn what the benchmark index earns, and charge a small fee for doing so.
Some hedge funds like Catana Capital’s innovative Data Intelligence Fund, don’t have a particular benchmark and don’t make promises about guaranteed returns. The fund’s prospectus explains the strategy and shows the fund’s returns. This is the realistic way to present an investment product.
2. Moving the goal posts
Another telltale sign of bad investments is that goals or benchmarks get moved when they are missed. This can happen when a financial advisor makes an investment recommendation that fails to perform. Rather than acknowledging the bad call, the advisor moves the goal posts by setting a new benchmark. Companies also do this when they repeatedly change strategy.
3. Delayed redemptions
If withdrawals from any financial product provider take longer than reasonable, or promised, there may be a problem. This is very common with unregulated forex brokers or asset managers. It often occurs when client funds are not kept in segregated accounts and are used for business expenses. It’s also a potential sign of a Ponzi scheme that uses new customer funds to pay redemptions. Redemptions from a fund may be suspended during periods of unprecedented market volatility. But they should not be suspended under normal market conditions.
4. No third party involved in administration of assets
Legitimate asset management companies typically involve a third-party administrator or custodian in the administration of assets. This means the asset manager does not have complete control of the client’s assets and prevents investment fraud. Third party compliance and auditors provide another safeguard against fraud.
This doesn’t mean the fund manager can’t make bad investments, but the alarm may be raised if risk limits are breached. If a company has a single bank account and no external service providers, the likelihood of customer funds disappearing is much higher.
5. Lack of liquidity
Typically, there are two ways for an investor to exit an investment. In the case of hedge funds, mutual funds and segregated accounts, a redemption request is made. The fund manager then sells securities and returns the cash to the investor. This situation is straightforward and there should be no problems. In the case of listed instruments, including ETFs and company stock, the investment is sold in the open market. Provided there is an active market for the security this will not be a problem either.
Problems arise when there is no active market for the investment. This can occur with very small listed investments. But, it’s more likely to occur with OTC (over the counter) shares, derivatives and structured products. If there is no buyer, you will not be able to sell the investment. A sure sign of bad investments are OTC products where the seller is the only market maker or promises to buy the investment back when you want to sell it. Typically, you will receive a terrible price or pay a hefty commission when you exit.
The investment warning signs above apply to investment products rather than stocks. The following 10 red flags apply specifically to companies.
6. Dividend cut
A company reducing the size of its dividend is a sure sign that things are not going well. Companies set their payout ratio at a level they are fairly certain they can afford. If they must reduce the dividend it means profits are under pressure and things are not going according to plan. Earnings will probably come under pressure and the lower yield will make the stock less attractive to investors. Both will probably lead to a much lower stock price.
Stocks with high dividend yields may appear attractive to income investors. What really matters, though, is how sustainable the dividend yield is. A stock with a lower yield than the prevailing interest rate can turn into a good investment if the dividend is sustainable and grows gradually over time. This gives you the benefit of both compound interest and capital gains.
7. Delayed release of results
If a company delays or postpones the release of its financial results, it will often mean bad news is on the way. It may also signal that the company’s auditors are reluctant to sign off on the results. Either way, it’s a potential early warning sign that the stock is a bad investment.
Another red flag is when companies schedule their results for late on a Friday or the evening before a bank holiday. They do this in the hope that Wall Street analysts will miss the result and the market will have more time to digest bad news. These are all signs that there is a higher risk that the company is struggling.
8. Changes in accounting policies
Occasionally companies will change their accounting policy when they report. These changes can affect the way inventory and assets are valued, the timing of revenue recognition and accounting periods. Business units can also be reorganized and moved from one segment to another. These changes are then applied to historical results as well as the most recent period.
There may be perfectly valid reasons for these changes. But reformatting the results is also a good way to hide problems. When prior periods are restated, current results may look better than they are. Changes in accounting policies are often followed by increased volatility for the stock price.
9. Executive turnover
Company management can’t be expected to stay at one company indefinably. But when there is a string of executive departures from a listed company, things may not be going well. Senior management at listed companies are often incentivized with long term share options. These options can become very valuable if the stock price rises. On the other hand, they will be worthless if the stock price falls or fails to appreciate.
If executives don’t think the stock price will rise, they may be better off moving to a different company with better prospects. This is just another sign of potential bad investments.
Asset write-downs are often investment warning signs for stock market investors. When a company buys or owns overvalued assets, they are typically listed on the balance sheet as intangible assets. If it becomes apparent that the real value of these assets is much lower, their values will be written down. A write down will reduce the value of the company’s equity and invariably the stock price will fall substantially. Write downs often happen over several quarters, leading to prolonged volatility.
When a company is in trouble, one of the first things that often happens is that communication with investors stops. If a company doesn’t have the answers, the easiest way to avoid awkward questions is to shut off the lines of communication. The transparency issue can also swing the other way. A company may switch PR agencies or hire a “reputation management agency.” A new PR agency isn’t always a sign of trouble – but it does mean you should pay attention.
12. Insider selling
Of all investment warning signs, insider selling is probably overstressed. There is nothing wrong with company insiders selling stock occasionally. But, if insider selling is ongoing, it may be worth paying closer attention.
13. Rising high debt
Rising and high debt levels are investment warnings signs. Debt can be a useful tool to improve earnings and profit margins. However, when debt is rising faster than the value of the company’s assets or equity it may mean debt is being used to fund operations. If the debt to equity ratio gets too high, the cost of borrowing will increase. This can create an unsustainable cycle that is difficult for the company to get out of. You can compare a company’s debt to equity ratio to the rest of its sector or industry to get an idea of what is reasonable.
14. Low ROE
A company’s return on equity, capital and investment are ultimately the ratios that tell you whether a company is making more than low risk investments. They are also a great tool for comparing companies. Ideally these ratios should be above 15% for most sectors. A low ROE (or ROI and ROC) means capital can probably be better employed elsewhere. If low returns persist, investors will probably move to better stocks. Low ROEs don’t always imply bad investments, but there should be a compelling case for the ROE to improve.
15. Valuation very low
Investors are often tempted to buy stocks trading on very low PE ratios. The idea of investing is to “buy low, sell high,” so this makes sense. This is a bit of an investing myth, especially when the price is too low. Very low PE ratios, particularly under normal market conditions should be viewed as investment warning signs.
If stocks fall to a level where the PE ratio is below 5, or well below historic levels, there is probably a problem. If large funds are not buying the stock at that level, it may be a value trap. It may mean that while the stock appears cheap based on past earnings, future earnings will be much lower. There may be potential for a turnaround, but it then crosses the investing vs. speculating line. Turnarounds are highly speculative and need to be treated with caution.
How to get out of bad investments
Occasionally you may find yourself stuck with bad investments. Sometimes you may miss investment warning signs, or there may be none. So how do you get out of a bad investment? It’s a good idea to get some independent investment advice from someone who really understands the type of product or security. The better informed you are the better.
In the case of a stock, you need an honest assessment of the value of the stock and whether the value is likely to rise or fall going forward. If you can sell for anywhere close to what the stock is worth, you should. There’s a lot to be aid for moving on to the next investment opportunity rather than dwelling on a bad stock.
If the investment is a product like a fund or a trading account, there may be a legal route to follow to recover your money. But before starting down that route find out exactly what it might cost and how long it’s likely to take. It may not be worth the time and money. There is no point throwing good money after bad money. Try not to be emotional. Focus on recovering what you can, rather than trying to recoup losses.
Reaching your investment objectives can take patience and hard work. A few bad investments that could have been avoided can make the process that much more difficult. By looking out for the investment warning signs and red flags listed in this article you can make things much easier and avoid a lot of stress.