In the investment world, there is no such thing as a sure thing. Even good investments can turn sour, given a dose of bad news or events outside your control. However, some investments carry warning signs, and those who heed these warnings have a much better chance of avoiding losses or identifying outright scams before they get burned.
Take a look at some of the most common red flags to help you learn what to avoid as an investor.
An Advisor Told You to Buy It
Just because an investment counselor recommends an investment doesn’t mean it’s bad. Brokers who work on commission, however, are not required to act as a fiduciary, meaning they are not required to place a client’s interest ahead of their own.
As some investments pay more commission than others, human nature might push a broker to recommend a higher-cost investment over a competing one. Always check to see how an advisor is paid before you invest.
You Need to Borrow to Buy It
Some sophisticated investors use margin — or borrowing — to leverage the effects of their investment. However, this is best left for high-risk traders. You might be better off picking a safer stock.
If you can’t afford to buy an investment outright and intend to borrow to raise the money, it might not be the best investment for you. In addition to taking on higher risk, you’ll pay interest on your margin loan just to buy the investment.
Everyone Else Is Buying It
Following the herd when it comes to investing is a big no-no. Sure, panic buying sometimes creates a frenzy akin to the Dutch tulip craze of the early 1600s. However, just like that bubble popped, “hot” stocks and markets often crash when the excitement passes and everyone heads for the exit at once.
Rather than buying based on what’s hot, do some research and learn about the fundamentals of an investment.
You Have to Buy It Now
Being pushed into buying an investment now before you “miss out” is a big red flag.
A good investment based on fundamentals is likely to be a good investment in a week, a month or even a year. If someone is encouraging you to hand over money immediately, it’s likely a scam — or at least the sign of a “hot” investment that is likely a bubble. Instead, stick to long-term, fundamentally sound choices.
It’s Down — a Lot
Just because something is lower in price doesn’t mean it can’t keep going lower. Some industry professionals refer to buying a stock that is dropping rapidly in price as trying to catch a falling knife.
Stocks that decline sharply often remain at lower levels for a significant amount of time — time that you can use to research the cause of the sell-off and determine if there’s still a reason to buy.
Warren Buffett Is Buying It
Just because someone else is buying an investment — even a noted investor like the “Oracle of Omaha,” Warren Buffett — doesn’t mean that you should buy it. Investors have different needs and time horizons, and Buffett’s reasons for owning a stock might be completely opposed to what your financial needs are. Find investments that are right for you, not right for someone else.
Stock Performance Exceeds Company Performance
A stock that goes straight up in value while its earnings remain flat or down could be headed for a fall. Typically, earnings drive stock prices, so a stock price that goes up while company earnings lag behind makes for a dangerous cocktail. Make sure to research a stock’s price-to-earnings ratio and try to find investments that are fairly priced or undervalued, rather than those trading at a high price-earnings ratio.
You Can’t Get Out
Some investments require that you hold them for a long period of time before you can sell them. Usually, this is a warning sign.
Variable annuities, for example, often have surrender periods during which you face charges of 5 to 9 percent for selling. Although variable annuities can have some merit in certain situations, look for alternatives that allow you better access to your fund.
You Got a Tip
A stock that has promoters singing its praises is usually one to be avoided. Scams often pop up after natural disasters like hurricanes, for example, with touts suggesting that certain event-related stocks will skyrocket. Do your own research, or stick to stocks recommended by analysts you trust.
The Investment Sounds Too Good to Be True
Trained salespeople know what people want to hear. If an investment sounds too good to be true, like most things in life, it probably is. Any pitches that use hyperbole — such as “incredible gains” or “huge upside with no risk” — are warning signs of a possible investment scam.
Stock Performance Trails Peers
Stocks, in general, tend to trade with the overall market, and particularly with their industry group. If a stock is underperforming its peer group, it could be a sign that it is undervalued.
However, it’s often a sign that the company is being beaten at its own game. Try to stick with industry leaders rather than with those that aren’t performing as well.
You Have Different Investment Objectives
Before you invest in anything, you should assess what your investment objectives are. Do you want growth of your capital, or do you need income? How about a combination of both?
Different investments offer different types of rewards. If an investment falls outside your personal parameters, that’s a warning sign that you probably shouldn’t invest in it.
It Doesn’t Match Your Risk Tolerance
Your risk tolerance is an expression of your appetite for volatility. Can you handle a stock that trades up or down 5 percent per day? Or would you be sick to your stomach just watching it?
No matter how good an investment might seem on paper, if you can’t handle the risk, that’s a sign that it’s a bad investment for you.
It Worked for You Before
Just because an investment worked out for you in the past doesn’t mean it will do so in the future. Heed the SEC’s warning that past performance is not a reliable indicator of future performance.
If you find yourself drawn to an investment simply because it turned a profit for you in the past, that’s a sign you need to do some more homework before you invest.
Insiders Are Selling
Insider selling of stock shares isn’t always a tipoff that a stock is going to go down, as corporate executives sometimes simply need to raise cash. However, if the top brass are selling large chunks of stock and no one on the inside seems to be buying, consider avoiding the stock for the time being.
You Don’t Understand It
If an investment is so complicated that you can’t explain it in simple English, that’s a warning sign to stay away. Just because an investment is arcane doesn’t mean it’s any better than the simple one down the hallway. With so many available opportunities to make money, stick to things you understand so you know what to expect.
Unregistered investments are generally intended for “accredited investors,” people with enough income or assets that they can afford to make mistakes. If you’re an average investor and are offered an unregistered investment, it’s a warning sign that you should avoid it.
Unregistered investments do not have to abide by the same securities laws and regulations that protect investors investing in publicly-traded stocks or bonds. So unless you’re a professional investor, consider sticking to traditionally regulated securities.
More on Investing Strategy
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- 25 Money Experts Share the Best Way to Invest $1,000
- 12 Essential Money Tips for Every Phase of Life
Joel Anderson contributed to the reporting for this article.