How to Recognize the Bad Ones
Investment decisions are some of the most important decisions we will make in life. Most people hope to save some money during their working careers so that they can have a comfortable retirement, put their children through post-secondary schools and even give their children and grandchildren a financial helping hand in life.
When one makes an investment decision there is always some question as to what to invest in. Mutual funds are very popular. Real estate is very popular. Some years ago, savings accounts were very popular. But the reality is that with these sorts of investments, one can expect a steady, moderate growth in the principal of the investments (with notable exceptions such as the “dotcom bubble burst” in 2000).
Sometimes, especially if one has been slow in life to start saving, it can seem attractive to take riskier non-standard investments. For instance, some investors have invested in real estate investment companies, rather than directly purchasing real estate, and received good returns on investment (note: some investors have lost all or nearly all of their money on such investments). Other investors have achieved good returns by having riskier portfolios with registered representatives in national and international investment companies. Other investors have achieved good returns in private equity placements. There are many options in Calgary, Alberta and Canada to make investments that, if successful, will result in a higher return than a traditional mutual fund.
Most, if not all, investors understand that in order to get a better reward, one has to take a bigger risk. Most investors have, at some point, put some money into a company that somebody said was “going to take off” only to be subsequently claiming that investment as a capital loss to use against capital gains for tax purposes (in other words, the investment went to $0.00).
But when investment dollars are lost, it does not necessarily mean that the reason for the loss is entirely the result of the risk taken. Recessions often result in losses in unconventional investments. However, recessions often have a habit of showing bad investment practices when the “water level drops”. Investors are less likely to look at their investments, and how they are being managed, when times are good and the investment is doing well. But when the investment drops, or goes to zero, investors are more likely to take a closer look at how their investment was managed, what fees are being paid and how the investment performed.
Nobody likes to lose money on investments, but the reality is that when an investment drops, it is not always because of market forces. Certainly, losses are sometimes the result of market forces, and investment managers will invariably claim that losses are entirely the result of market forces, but the reality is that sometimes investments go bad for bad reasons.
It is a good idea to watch all of your investments all of the time, particularly in good times. When lawyers look at investments, inevitably after the investments have lost part or all of their value, there are often certain markers that could have indicated to investors that they were not receiving enough return in the good times, and then when the bad times inevitably came, the investment was headed for trouble.
Typical markers (or “red flags”) that can be identified include:
- Overvaluing or high valuing of assets in a portfolio. This is particularly the case with assets such as real estate which always have only “estimated” values. Often an investment can look really good in the good times, and then eventually investment managers are forced to put a more realistic value on assets, and the loss to the investment looks even worse. While there is nothing that an investor could later sue over in this instance, this is a marker of future problems.
- Non arms-length transactions. This marker is closely related to the above note, since often non arms-length transactions are conducted at an inflated value. A common such transaction in a real estate investment is that the management team purchase a property in a numbered company, and then sell it to the investment group (that they manage) for an inflated price, suggesting that this inflated price represents the true market value of the project. Usually the details of this non arms-length transaction are fully disclosed in an offering memorandum, but the high sale price usually means that the investors have overpaid for the property such that there is no hope of ever seeing a return on investment, and their investments are immediately in jeopardy. There are other similar examples of this type of marker.
- High management fees. In fairness, investors in mutual funds can ask this question also, but this marker is very common in private investments. Generally speaking, when an investment is doing well, investment managers should make more money. When an investment is doing poorly, they should make less money. But when investments are doing well, there is an unfortunate trend for investment managers to take more than they ought to. These situations are not always necessarily illegal, given the contracts in some private investments, but this is certainly a marker of future problems. In these cases, the investment managers often defend their actions by pointing out that the actual investors are passive investors and that the manager is the only one successfully operating the company and the investors should be pleased with the great return they are getting and not be worried about what fees and expenses are being collected by the investment manager. This is a marker to watch closely as an indicator of future problems.
- Obviously fraud, by its very nature, is difficult to detect. But if an investor is at all wary of something fraudulent, or questionable, going on with the investment, then it is better to ask questions, and even to get one’s investment out and take it somewhere else. In most investments that are alleged to have involved fraud, there was always someone along the way that raised uncomfortable questions and was encouraged to take his/her investments elsewhere. Those are usually the happiest investors. It is difficult to know when this is going on, because alleged fraudulent persons generally are some of the best storytellers and usually have fantastic explanations as to why things are happening. Just remember to ask questions early and to remember what the RCMP tell Canadians – if something looks too good to be true, it is.
If one loses his or her investment, or a portion thereof, there are legal means to try to recover the investment losses. There are many such lawsuits being litigated at any given time. These sort of lawsuits usually result in some recovery for the investor and as such they are worthwhile, however often the recovery can be as little as 25 – 50 cents on the dollar. Sometimes recovery is less, depending on what is left for investors to claim against. As such, the happiest investor is one who is able to recognize bad investments ahead of time and get his/her investment dollars somewhere else.
McGuigan Nelson LLP