The Process of Elimination

I always like to apply the process of elimination when making financial decisions because figuring out what to avoid is where most of the value can be found in a long-term process.

When performing due diligence on a current or potential investment manager or financial advisor there are some signs you can look for that will give you an idea about who to avoid and who is worthy of your time. Here are some of those red flags to look out for:

1. Only show gross returns. If a fund or advisor tries to show their gross performance before all fees as what you can expect as an investor that’s a big red flag. The only performance that matters is what the investor receives net of fees. Investment firms have to be completely up-front and honest about the all-in, total fees they change investors.

2. Guarantee a specific (high) performance number. It would be great if you could target a certain level of performance and take just enough risk to obtain that number to reach your goals. It would make life a whole lot easier. But the markets don’t work like that. No strategy can give you a guaranteed 10% or 15% a year return figure like clockwork. It would be nice and it’s tempting to believe when someone makes that promise, but it’s a false hope and a pipe dream.

3. No transparency. “Trust me, I got this,” is not a legitimate selling point for an investment strategy. If someone can’t explain their process to you at a high level in 60 seconds or less in language you can understand it’s not a good sign. I’ve always found that the longer it takes someone to explain their investment approach the worse off it tends to work. And unless you’re meeting with Jim Simons of Renaissance Technologies, you should be wary of black box strategies that won’t offer exactly how their process works.

4. All sizzle but no steak. It feels safer and more comfortable to invest with an organization that has a great sales and marketing team. And sometimes you can find firms that have a solid investment process and can make a great sales pitch to you about it. But it’s a red flag if you’re being sold a narrative with nothing substantial to back it up. If something sounds too good to be true, it probably is, especially when financial service are being involved.

5. An exclusive focus on performance with no mention of risk management. An impressive return on your investment seems like a logical goal for many. The problem for most is getting from Point A to Point B. Almost anyone can earn a profit in the short-term. Being able to make money over time without blowing up your portfolio requires risk management. If an advisor or fund manager only presents potential rewards without a balanced perspective that also points out the risks involved they are being disingenuous or potentially deceitful. Risk management not only entails being honest about the potential pitfalls of a strategy, but it also requires an understanding of you as a client. There needs to be an honest assessment of an investor’s ability to handle the inherent risks in a given approach.

6. No focus on client education. Not every strategy is suitable or appropriate for every investor. One of the best ways to reduce the behavior gap for investors is to make sure they understand exactly what it is they are getting themselves into. There are plenty of firms out there that are very good at selling investors on the merits of their strategy. But there are very few that excel at actually educating their investors, which happens to be one of the best ways to develop good long-term clients. Education helps ensure that investors don’t bail at inopportune times or make irrational short-term decisions with long-term capital.

As the level of outperformance in the markets continues to narrow, client education will only increase in importance as a large value-add for investors. I think it’s a huge red flag if an organization doesn’t make client education a priority.

Further Reading:
Observations on the Investment Process
The Difference Between an Investment Firm and a Marketing Firm
Should Fund Managers Care About the Behavior Gap?

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  1. innerscorecard commented on Mar 02

    Do you think #2 also applies to company managements that aim for extremely specific targets?

    • Ben commented on Mar 02

      Makes sense to me. Anyone that aims for exact precision in the financial markets it doing it wrong. It only leads to mistakes.

  2. SHOfan commented on Mar 02

    Great article. Every investor should read this.