What is a bad investment decision?
While what defines a bad investment decision varies by each investor, in general, it's an investment that detracts from you achieving your financial goals. It might be a stock, exchange-traded fund (ETF), or mutual fund that loses money. It could also involve:
- Making an investment with higher expense levels than you are comfortable with.
- An investment that charges high upfront commissions or sales charges.
- Investments that restrict the ability to make a change through high surrender charges.
- Having an investment that involves more risk than you are comfortable with.
A bad investment might not be just a single investment, but rather a bad investment strategy. For example, you may find that your investment portfolio is not diversified enough. In other words, you may be too concentrated on one type of investment.
Having a concentrated stock position could happen as a result of investing in your employer’s stock via a 401(k) plan or a stock purchase program. While investing in your employer’s stock can be a good decision, having too much of your portfolio concentrated in that stock (or any stock) can expose you to too much potential risk if the stock price falls. In this case, it could be considered a bad investment decision.
How to avoid bad investment decisions
The best way to avoid bad investments is to become as knowledgeable about investing as you can. Read everything you can — financial newspapers, analyst reports, even earnings numbers! Talk to experts when you have the opportunity.
There is no 100% foolproof way to avoid making a bad investment, or at least one that doesn’t work out in the way that you expected. Even legendary investor Warren Buffet has made some investments he now regrets.
Some investors might seek professional investment advice from a financial advisor and that can help. But even professionals can make bad investments. The key is to try and minimize these bad investments. Here are some other suggestions on how to avoid making a bad investment decision:
Understand what you’re investing in
The key to avoiding bad investments is to understand what you are investing in as well as your own investment objectives.
Understanding what you are investing in is critical. All too often, some financial salespeople prey on an investor’s lack of knowledge and sophistication to sell them investments and financial products that are not right for them. If you don’t understand something, ask! Just because someone sounds smart doesn't mean what they're selling is a good investment for you. Never be afraid to walk away.
If you do use a financial planner or advisor, it’s best to seek out someone who is a fiduciary. A fiduciary advisor is legally required to put your interests above their own.
Avoid investments with surrender charges
Some investments, such as annuity products, have high expenses and long surrender periods. A surrender charge is a fee for exiting the annuity within a set period of time. I’ve seen surrender periods on annuities that exceed 10 years. There is nothing wrong with an annuity, but the problem lies with those that have high expenses that detract from the returns realized by the contract holder. Surrender charges can also limit your liquidity, meaning you can’t get out of the investment as quickly as you’d like.
Avoid brokerage wrap-accounts
Brokerage wrap-accounts are managed accounts offered by a number of brokerage firms. These accounts often use high-cost mutual funds that compensate the brokerage firm in addition to the account management fee you pay to them. You should avoid brokerage wrap-accounts in particular if you’re a buy-and-hold type of investor.
Be cautious of funds with upfront sales charges
Mutual funds or other funds can have an upfront sales charge and many expenses that can seriously eat into your bottom line. If you’re going to invest in a mutual fund, make sure you understand all the fees being charged so you’re not surprised when it’s time to withdraw your funds. Upfront sales charges can also be a bad decision because it means the advisor has no incentive to continue giving you good advice or keep you abreast of fund developments.
Diversify your investments
It’s never a good idea to only have one type of investment — whether it’s investing in stocks, real estate, bonds or some other alternative investment.
Instead, focus on diversifying your portfolio, even within asset classes. For example, you can invest in a variety of stock sectors, some bonds, and real estate. The basic idea is to spread your investments out to withstand the volatility in the market. What you should diversify in or how you should spread your assets depends on a lot of individual factors such as your age, types of investments, and aptitude for risk.
How to handle a bad investment decision you’ve already made
We all learn from our experiences and investing is no exception. If you’ve come to the conclusion that you’ve made a bad investment, sometimes the best course of action is to cut your losses.
- Some investments are easier to sell than others. Investments like mutual funds, exchange-traded funds (EFTs), and stocks are more liquid. These and other securities can be sold anytime the markets are open. At worst, you may have to deal with a gain or a loss on the investment; if it is a mutual fund with a surrender charge you might incur that cost. If the transaction is done inside a tax-deferred retirement account, gains or losses will not be an issue.
- However, some types of investments are illiquid, meaning there is not a readily available secondary market where there are buyers. Illiquid investments can include real estate, most hedge funds, and private equity funds. Real Estate, for example, must be put on the market and a willing buyer must be ready to pay for the property.
- Private investments such as hedge funds and private equity funds may have limitations on when investors can withdraw their money. Redemptions are generally the best route to exit such investments. If you own stock in a private company, you will need to sell those shares to another willing buyer or perhaps back to another owner of the company.
- If you made a bad investment as a result of a relationship with a financial advisor, move your accounts away from that advisor and try to get out of the investments that you think are bad. We recommend using Paladin Registry.
Learn from your mistakes
Investing can be a lifelong learning process. Even experienced investors make bad decisions on occasion. The key to avoiding making the same mistake over and over is to learn from those bad decisions. Apply that knowledge to your future investments. Don’t be afraid to admit your investing mistakes and move on. Trying to salvage a bad investment can be time-consuming and may leave you in a worse position than simply cutting your losses and moving on.