Before you buy any investment, you need to fully understand what you are buying. There are many hidden traps you could fall into. It’s what you don’t know that will hurt you. That’s why you need these five questions answered. They will help you make better investment decisions:
1. In one sentence, what exactly am I investing in? Keep things simple. If you or the person selling you the investment can’t explain in one sentence what you are investing in, then the investment might be too complicated. If so, don’t buy it.
2. Does this investment fit into my plan? Make sure the investment meets your own personal goals. If you want no risk of fluctuation, you’ll focus on money-market funds, short-term CDs, and Treasury bills. If you have a long-term horizon and can withstand higher levels of fluctuation, then stocks may be what you need. Make sure the investment accomplishes your mission and fits into your portfolio goals. Don’t worry; you might not know the details of your portfolio goals now.
3. What are the risks involved in owning this security? Risk is always a confusing subject because there are so many different types. There’s inflation risk, fluctuation risk, and company risk. However, risk management is beyond the scope of this article.
4. Is there a secondary market for this investment? This question is important and yet so few investors ask. A secondary market is simply a place where you can sell your investment whenever you want. Once you purchase a security, you must have a secondary market that will allow you to sell the security later. If the security is a stock listed on the NYSE, then you know there is a real secondary market. If it is a packaged, then you need to stay away. Markets do change, and you need to know whether you can sell the investment later. If there is no established secondary market, the security is illiquid, and you should avoid it. Most investors don’t appreciate the need for a secondary market until they suddenly need one. Without a secondary market for your investment, another problem is getting daily and monthly pricing data. No one is making regular transactions, so there is no source for current prices. If there is no way to get an accurate price each month, you’ll rarely know what your investment is worth. Therefore, the price on your statement each month is an estimate. If you have owned limited partnerships before, you understand what this is like. It’s not fun. Full-service brokerage firms that sell limited partnerships are known for using the original purchase price on the monthly statement. Many of them have stopped this practice.
5. What will this investment cost me? Investment costs are easy to hide. If you buy a stock from a brokerage firm, you are charged a commission on top of the purchase price of the stock. What can be hidden from you is an additional commission, which is part of the spread. The spread is the difference between the price the brokerage firm paid for the security and the price at which it sold the security to you. Brokers are only able to do this with over-the-counter (OTC) stocks because the NYSE no longer allows this practice. Bonds are different in that the commission is part of the price you pay for the bond. You may never know the commission. It is usually measured in percentage points. (One percent equals $1,000 commission.) Short-term bonds are easier to sell, and therefore, the commission can be a fraction of a point or a point. Long-term bonds can have as much as 5 percentage points in commission. Even if you ask the broker, how many points did this bond pay you? You might not get a straight answer. However, the broker may be amazed that you even knew to ask.
Commissions are hidden from the investor in more ways than even an experienced investor know. You can always look in a prospectus when buying a mutual fund. You can also ask this question: If I sell this investment tomorrow and the price of the security remains unchanged from today, what will it cost me? This is a great question. If you proceeds are significantly lower than your original purchase price, don’t buy the security. It’s probably a commission trap.