How to Tell if a Client’s Investment is Too Good to Be Trueby
Investors can be easily seduced. Often, they buy securities they don’t fully understand, but the story sounded spectacular. You’ve seen the late-night TV ads for making money in real estate or reasons to buy gold coins now.
Unfortunately, accountants usually learn about these missteps after the fact. Yet, sometimes clients call and ask for advice.
An Investment is Too Good to Be True if …
You’ve likely come across these scenarios before:
1. The return is sky-high. Clients buying this investment are promised a rate of return of 10 percent or more. As of Jan. 9, 2017, the 10-year US Treasury bond is yielding 2.374 percent.
Questions to ask: Exactly how are they getting this rate of return? If the US government can raise money at a cost of 2.374 percent, isn’t it logical that the feds would be buying this and making 7.626 percent on their money? They aren’t.
2. The return is guaranteed. “Guaranteed” is a dangerous word. Few things qualify. The interest you earn on an insured bank account might meet this standard.
Questions to ask: Who is providing the guarantee? What happens if the firm goes under? Personal guarantees from a financial advisor are illegal.
3.Your principal is guaranteed. Also, “you can’t lose money.” There is a difference between a government guarantee and one from the private sector.
Questions to ask: Often, insurance products, like annuities, provide a guarantee of principal in the accumulation phase. You are investing based on the integrity and financial stability of the firm. Insurance companies are rated by independent services. What kind of rating do they get?
4. The cash flow is 8 percent. This sounds like income, but it’s not. The investor might be receiving a blend of interest and his or her own principal. Mortgage-backed securities often work in this way.
Questions to ask: Is all of this interest? Am I getting some of my own principal back, too? Why are you calling it cash flow instead of dividends or interest?
5. Immediate liquidity. Also, “you can get your money back anytime.” As of Jan. 9, Schwab’s government money market fund has a seven-day yield of about 0.01 percent. The Schwab Value Advantage Money Fund has a seven-day yield of 0.54 percent. Money market funds are popular because of their liquidity features.
Questions to ask: How are they protecting you? Does immediate liquidity mean you can take money out, but with some principal risk? Most listed securities are liquid at market prices on a T+3 basis. (Settlement three days after you place the order.)
6. No fees. This doesn’t exist. The person selling the security is being paid. There may be a declining surrender charge, encouraging you to hold the investment for several years, but they are still amortizing fees over time.
Questions to ask: If there are no fees, how do you get paid? If I decided to sell tomorrow, what would I get? Does no fees mean “no additional fees?” Are there fees built into the purchase price of the product?
7. Great track record. Sometimes the security didn’t exist previously. Then it’s called “backtesting.”
Questions to ask: I’ve heard “past performance is no guarantee of future results.” It’s most often applied to mutual funds by US Securities and Exchange Commission policy. Does that also apply to this investment?
7. No risk vs. low risk. “No” is an absolute term. “Low” is relative.
Questions to ask: What does “no risk” mean? Can I lose money? Can I get back my money anytime I want it?
Warning Signs That the Investor Should Learn More
Your client might mention a few points in passing. These deserve more attention.
1.Lots of papers to sign. This likely means the client is accepting a degree of risk, or signing away some of his rights. If he is required to sign papers, he should read them first. If he reads them, he should understand them. If he doesn’t understand them, he shouldn’t sign them.
2.I can’t explain how it works, but it’s good. Your client must be able to articulate to another person (her spouse) how the investment makes money. Most people are pretty smart. If she doesn’t understand how it works, that’s a red flag.
3. It’s everything I want. No investment ticks all the boxes. If it provides growth of principal, current income, immediate liquidity, and principal protection, something is wrong.
4. Not listed, private placement. This means you can’t check the current value. You must take someone else’s word for it.
5. Limited liquidity. The issuer may specify a window every few months when liquidations can be requested. Often, the price is based on its valuation of the securities. The issuer often has the right to change the rules.
6. Nontransferable. The security is proprietary to one specific firm. If you chose to move your account elsewhere, this security would remain. The firm controls liquidity.
7. Time pressure. Although salespeople like to create a sense of urgency, there should be no reason why you must buy now or lose the deal of a lifetime.
Investing makes sense for most people. Different people have different risk tolerances. The above points are warning signs your client might not be working with the right financial advisor. Perhaps you can recommend a few alternates.
Bryce Sanders is president of Perceptive Business Solutions Inc. in New Hope, Pennsylvania. He provides high-net-worth client acquisition training for the financial services industry. His book, Captivating the Wealthy Investor, can be found on Amazon.com.