Five Red Flags That Every Investor Should Know About

by Frank Wehr

When it comes to picking an investment advisor or individual investments in today’s market, it can be very difficult to decide, “What is right for me?”  Many novice investors find themselves in a financial position to make investments, but are simply afraid to take the advice of brokers or take a chance on an investment.  It is easy to see why people are so hesitant when it comes to trusting the advice of a broker.  There is certainly no shortage of stories in the news today about crooked brokers and their brokerage firms and the investors that lost everything on an investment that was supposed to be a “sure thing.”

But it’s not all bad.  Believe it or not, most brokers are smart, professional financial advisors who put investors’ interests first.  Nevertheless, it is important for investors to know what to keep an eye out for when deciding to invest with a particular broker.  The following is a list of 5 red flags that should put every investor on alert.

Note – just because you have experienced one of these red flags does not necessarily mean you have fallen victim to a crooked broker.  However, if you have experienced any of these red flags, it might be time to have a conversation with your broker or perhaps consult another advisor for a second opinion.

1. No Risk Of Principal

Many investors find themselves looking for a way to make higher returns than they would if they left their money in savings accounts, but do not want to risk their principal.  While there are many low-risk options, such as various government bonds and some mutual funds, there is simply no such thing as a totally risk-free return.  Any assurance by a broker that an investment or product offers a totally risk-free return should put the investor on immediate alert.  If your broker tells you a product offers a risk-free return, ask her to guarantee in writing that you will not lose your principal.  That leads me to my next point….

2. Guarantees

FINRA (Financial Industry Regulatory Authority), which oversees all brokers and firms, explicitly prohibits brokers from making guarantees about the performance of an investment.  Every investor wants assurances that they will make money or that they will not lose money.  But, if your broker is making promises against losses, she is also putting her broker license at risk.  Investors should always ask their brokers for explanations of the risks involved in an investment and the reasons why the broker thinks an investment might perform a certain way instead of counting on guarantees.  If the only way a broker can sell you an investment is by making promises about it, you probably do not want anything to do with the product… or the broker.

3. Repayment of Losses

This applies to investors who have already taken some losses and their broker or investment advisor wants to cut them a personal check to repay them for those losses.  Seems like you might have a real stand-up broker who genuinely feels bad about the losses you have taken, right? WRONG! This is highly unethical and would be grounds for termination of any broker caught doing so by their firm.  FINRA rule 2150(c) and every brokerage firm, which is governed by FINRA, prohibit brokers from personally repaying clients for their losses.  If you find yourself holding a check for your losses with “Sorry” in the memo line, it is time to talk to a supervisor.

4. An Investment You Don’t Understand

With the amount of complex investment products and technical jargon that get thrown around by finance professionals, it is easy to see how so many investors can get confused.  For this reason, many investors put their full faith in their broker and purchase recommended products they do not fully understand.  They figure, “I do not really need to understand these products as long as my advisor does.”  Even if your broker is a friend or family member, this is an extremely risky strategy.  If you purchase a product you do not truly understand, chances are you also will not understand your broker’s explanation of why you lost a quarter of your principal investment over a 3-month period either.  When it comes to the more complicated investment products—i.e. UITs, REITs, etc.—the devil is really in the details and often times so is the risk. Furthermore, many of the more complex products, are more expensive to own due to maintenance fees—fees you might not understand without a fulsome understanding of the product itself. But, you do not need to pass the Series 7 to understand what’s in your portfolio.  You should feel comfortable asking your broker to explain how a particular investment functions and why it is appropriate for you.  Put more simply, if you do not understand it, ask your broker to explain it again.  And if you still do not understand it, ask for something else.

5. Penny Stocks

Penny stocks are equities that trade for less than $5 per share.  Penny stocks seem appealing to some investors as they can offer the opportunity to purchase a considerable number of cheap shares early on in a company’s life.  When a penny stock company hits it big—like Monster Energy Drinks, True Religion Jeans and Pier 1 Imports all did—holders of their penny stock stand to make huge returns.  But, most people don’t realize just how speculative penny stocks are and how rarely they make money for their investors.  Most penny stocks are offered by young, small, unproven companies without sufficient capital to run their business. As a result, many penny stock companies go bankrupt and lose all the money invested by their shareholders. Not to mention, penny stocks are a favorite vehicle among financial criminals to defraud and steal from investors.  According to FINRA, penny stock fraud is one of the top 5 most common types of financial scams out there.  The point here is that your broker should NEVER recommend penny stocks unless you specifically ask for something speculative and you are willing to lose all the money you invest in them.  In most cases, you would be better off putting your money on the craps table than in a penny stock.  At least in the casino you get to roll the dice.