How To Avoid Losing Investments Before They Cost You Money With A Few Simple Due Diligence Questions.
Ignorance about investing isn’t bliss… it’s expensive. What you don’t know about investing will cost you money. Due diligence is the cure.
Due diligence is the critical skill that separates the professional from the amateur investor. You must know which questions to ask so that you can make more intelligent and profitable investment decisions. This includes determining what strategic function the investment serves in your portfolio, the risk profile for the investment, and how to manage the known risks to control potential losses should the investment go bad.
“A prudent question is one half of wisdom.”
Francis Bacon, Sr.
Amateurs do just the opposite and act irresponsibly by risking their hard earned dollars on hunches, articles they read, brokerage investment advice, or hot tips without first performing due diligence. This invites unnecessary and avoidable risk that can result in catastrophic losses.
My advice is to adopt the habit of investigating all investments first before ever putting a dime of capital at risk. Do your due diligence. Sure, it’s a pain and sometimes takes hard work, but getting answers to the tough questions up front can save you from expensive losses down the road. There is simply no substitute for investment due diligence because it’s what you don’t know that will cost you.
Below are the first two of five due diligence questions explained in this first article as part of a two part series.
Due Diligence Question #1: How Can I Lose Money With This Investment?
This question is so important I’m tempted to throw away the remaining four questions and just repeat this one over and over again until I drive you nuts. You don’t know an investment until you understand all the ways you can lose money with it.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
I cannot overemphasize the importance of this question. You must first focus on the return of your capital, and only second concern yourself with the return on your capital.
My advice is to first find all the ways you can lose money with an investment by identifying in advance all the major risks that can lead to losses. Once these risks are fully identified the second step is to pro-actively manage away whatever risks are manageable. I explain this two-step due diligence process in greater detail below:
The First Step in Risk Management is to Identify the Risk Profile
Your first job is to identify all the ways you can lose money with a particular investment. You do this by identifying and grouping the risks associated with that investment
You may be surprised just how much risk is manageable. With proper portfolio design and investment strategy you can usually manage away every significant risk except one or two to acceptable proportions for any given investment. These one or two remaining risks define the specific, uncontrolled risk profile for every investment. It is the leftover risk you must live with.
“All of life is the exercise of risk.”
William Sloane Coffin, Jr.
In order to manage away the risks of loss you must first know what risks are inherent to the investment you are considering. Using the stock market as an example, there are almost a limitless number of risks, but for practical purposes they can be profiled down to a few major categories:
(1) “Company specific” risks include things like accounting scandals, lawsuits, and mismanagement – anything unique to the company that is not part of the industry. These risks are managed away by diversifying among multiple companies. Mutual funds and exchange traded funds are great examples of simple, cost effective tools to diversify away company specific risk.
(2) “Industry specific” risks include a downturn in demand for widgets, changes in consumer tastes, disruptive technology changes, and industry law changes. This risk is controlled by not concentrating your portfolio in a single industry.
(3) A closely related risk is “investment style” risk such as value vs. growth or large cap vs. micro cap. The market will vary how it rewards or punishes different investment styles over time. For this reason, you should manage this risk by not concentrating too heavily in any one specific investment style like micro cap, value, or growth.
(4) “Market” risk is associated with a general downturn in investor’s appetite for stocks causing an overall reduction in the valuation level of equities. This risk is manageable through a sell discipline, hedging, or by diversifying into non-correlated markets such as real estate, commodities, cash, or international equities rather than solely domestic equities.
Again, the above risk profiles are designed to illustrate stock investing. However, the same principles can (and should be) applied to every asset class in your portfolio. For example, if you invest in real estate you would not want all your assets tied up in one property, or one city, or one type of property. It is wiser to diversify away those risks that can be managed rather than concentrate them.
The Second Step in Risk Management is to Create a Controlled Risk Profile
Once the risk profile for an investment is fully understood, your job as risk manager is two fold. First you must design ways to manage away whatever risks can be eliminated, and second you must accept only investments where the remaining uncontrolled risk profile doesn’t overlap with other investments in your portfolio. The end result is a minimization of the total risk for the entire portfolio because it is composed of mostly uncorrelated, managed-risk investments.
Why bother with all this? Because lower risk means losing less money when you are wrong. That is important because, as you will learn in other articles on this site explaining the math of compounding wealth, losing less when you are wrong results in making more when you are right.
“Often the difference between a successful person and a failure is not one has better abilities or ideas, but the courage that one has to bet on one’s ideas, to take a calculated risk – and to act.”
Your ability to manage risk is limited only by your knowledge and creativity. The critical point to understand is that each investment has unique risk management tools available that result from the unique characteristics of the investment and the market it trades in.
For example, one of the largest risks to income producing real estate investors is a change in interest rates since mortgage interest is one of your biggest expenses. This risk can be managed by locking down long term, fixed rate, fully amortizing financing.
You can also limit your loss in real estate to the amount of your down payment through the use of non-recourse financing thus controlling the risk of additional capital losses should your property turn into a loser.
Notice that these two financing tools for managing risk are unique to real estate and are not available to investors in business or paper assets (the other two primary paths to wealth).
Each market has its own unique characteristics for managing risk, and the paper asset markets are no different. For example, most securities markets offer high liquidity and low transaction costs making them a natural candidate for cost effectively managing many risks through a sell discipline. In fact, many mutual funds have zero transaction costs and daily liquidity through their commission free exchange privilege.
However, using a sell strategy in real estate to control downside capital risk doesn’t make as much sense compared to paper assets because of the prohibitively high transactions costs and possible low liquidity during tough market conditions when you would want to sell.
In short, each market has unique characteristics that can be exploited to effectively manage the risk inherent in that market. What works in one market to lower risk may not apply in another market.
In summary, your first due diligence question is to uncover all the ways you can lose money with an investment. The first step in this process is to profile what the risks are with the investment and then determine the unique characteristics of that investment to develop strategies to control losses should the worst come to pass. This is the essence of risk management.
“And the day came when the risk to remain tight in the bud was more painful than the risk it took to blossom.”
After you have managed away all risks that can be eliminated, you are left with a specific, uncontrolled risk profile for that investment. Your final risk management step is to make sure the remaining risk profile doesn’t correlate with other investments in your portfolio.
For example, when I purchase apartment buildings they are financed with long-term, non-recourse debt to control both interest rate risk and to minimize total risk of loss should Murphy’s Law prevail. In addition, each building is located in a different geographic market to assure the uncontrollable risk profile associated with location doesn’t correlate to other assets in my portfolio. That is walking my talk.
Focusing on risk might seem pessimistic to many, but my experience is quite the opposite. Investing is by definition a game of greed. The objective is to make money so the game is naturally played offensively by looking for the profit. By disciplining yourself to look for the loss, you will bring much needed balance to the investment equation. That is why risk management is so important.
The hallmark of great investors is not just strong positive returns, but consistent returns through all market conditions. This can only be achieved by focusing on controlling losses through a risk management discipline. You begin this risk management discipline with the due diligence question, “what are all the ways I can lose money with this investment?”
Due Diligence Question #2: How Will This Investment Help Me Achieve My Personal and Portfolio Objectives?
The portfolio objective for most investors interested in building wealth is to maximize profit with minimum risk. You achieve this goal by building a diversified portfolio of non-correlated, risk managed, high mathematical expectation investment strategies that capitalize on a competitive advantage in business, real estate, and/or paper asset investing. (Sorry, I know it is a mouthful. Read it twice. There is a lot of meat in that sentence.)
But it’s not enough to just have a portfolio objective – you must also have a personal objective. Your personal objective for investing is to achieve your portfolio objective in a way that honors your personal values, skills, and interests. You are a unique human being who must travel his own path to success. After all, there is no point in climbing the ladder to success if it is leaning against the wrong wall for you.
“Success with money, family, relationships, health, and careers is the ability to reach your personal objectives in the shortest time, with the least effort and with the fewest mistakes. The goals you set for yourself and the strategies you choose become your blueprint or plan. Strategies are like recipes: choose the right ingredients, mix them in the correct proportions, and you will always produce the same predictable results: in this case financial success.”
Charles J. Givens
Investment success is a lifelong process and humans are not robots. The only way you will stay the course long enough to succeed is when the investment strategy used uniquely fits your interests, skills, goals and resources thus providing emotional satisfaction. One of the biggest obstacles to success is getting distracted by the endless opportunities that will cross your path. There are many ways to make money investing, but I recommend you find the one or two ways that are going to work for you and not get diverted by all the rest. You must stay the course long-term until you succeed.
For example, I’ve worked with successful real estate investors in single family homes, commercial real estate, mini-storage, office parks, mobile home parks, notes, apartments and more. Yet, seldom do I meet successful investors who are actively working more than one of these investment niches at any one time.
The smorgasbord approach to investing doesn’t work because each investment specialty has its own twists and turns that require specialized expertise. Each niche has its own network that you must plug into for success. Each niche requires its own specialized skills and competitive advantage. Nobody can or should be a master of all investment strategies because any one offers more than enough opportunity to reach financial freedom.
For that reason you must determine which niche has the inherent characteristics that best fits your interests, investment goals, and risk tolerance because that is where you will discover wealth, happiness and fulfillment. Not every investment alternative is suitable for every investor. Your job is to find the one uniquely suitable for you.
For example, every investment has an “active” and “passive” component to it. If you don’t want to be a “hands on” real estate investor then professionally managed apartment complexes make more sense than single family homes. Even greater passivity can be obtained through paper asset investing if that fits your objective.
“Success is the progressive realization of worthwhile, predetermined, personal goals.”
Paul J. Meyer
However, if you are aged 55 and just starting to build for retirement then beware of investment advice pushing you toward passive investments like paper assets because your situation may require the leverage only available in business and real estate to allow you to make up for the late start and still achieve your financial goals.
In summary, if you want to succeed investing then you must make sure Step 2 of your due diligence process analyzes each investment for congruence with your personal and portfolio objectives. Below is a summary of the key points in the second due diligence question:
(1) Each paper asset investment strategy must have a positive mathematical expectation, and each business or real estate investment strategy must have a competitive advantage or exploitable market edge to place the odds of profit in your favor. This is the source of your investment return.
(2) The source of investment return must persist long enough into the future to be reliably exploited (adequate sample size).
(3) The investment strategy must be consistent with your personal skills, interests, values and abilities.
(4) The investment strategy must be consistent with your portfolio objectives.
(5) You must follow the investment strategy long enough to benefit from the competitive advantage without being distracted by other investment alternatives.
When your investment passes these tests then you can be confident of it helping you reach your personal and portfolio objectives. Your financial coach can be particularly valuable in clarifying these principles and how to apply them because he has no conflict of interest biasing his investment advice since he sells no investment products.
(This article continues in Part 2 – Five “Must Ask” Due Diligence Questions Before Making Any Investment)