All investment requires giving your money to someone else. Even the most conservative investments, such as bank accounts or money market funds, involve giving your money to a bank or mutual fund management company. When you buy a stock from a company, you give the company your money in exchange for the stock. Therefore, the question is whom to trust?
Deal with the known. Why risk your retirement with a person or firm you don’t know anything about?
Invest in an asset, not a person. Never make an investment because you like the person selling it. The attractiveness of the investment is a reason to invest, not the attractiveness of the person selling it. A really nice guy selling an investment in an ostrich farm guaranteed to produce 100% profits in six months is someone you don't want to get to know.
Federal deposit insurance protects your bank accounts up to certain limits. Regular bank accounts are covered up to $100,000 and retirement accounts are covered up to $250,000. Be careful if a bank tries to sell you mutual funds, annuities, college savings plans and other financial products that are not traditional bank accounts. Banks often sell a mix of deposit accounts that are federally insured and other financial products that have no federal deposit insurance coverage. Make sure you understand whether or not the product you are buying is federally insured. If you can’t get a clear picture, leave and go to the next bank down the street.
In order to save and invest, you have to give your money to other people. This is true whether you manage your finances yourself or use a financial planner. The need to give your money to someone else is intrinsic to investment. Hiding cash underneath the mattress doesn’t generate profits. The only way you get profits or earnings on your money is to give it to someone else who will pay you interest or dividends, or invest it for your benefit.
The financial services industry specializes in taking your money and investing it for you. On the simplest level, this is what banks do. They take your money and pay you interest. That interest comes from profits the bank gets by lending or otherwise investing the money you deposit. Your deposits don’t just sit in the bank’s vault. If the bank didn't lend or invest your deposits, how would it get the income to pay you interest?
Other financial services firms, like stock brokerage firms, purchase stocks and other investments for your account as you instruct or authorize them, and you give the stockbroker the cash to pay for the investments. In effect, you place some of your assets in the hands of the stock brokerage firm.
Mutual funds, which we have already covered in our discussion of managing investment risk, take money from you and give you a proportionate ownership in the stocks, bonds and other investments they buy for you and other mutual fund investors. Thus, they, too, end up holding assets for you.
Some people turn their money over to financial planners to invest. Other people buy investments directly from people who are selling them—such as stock promoters or the company issuing the stock. In all these instances, your money winds up in the hands of other people.
Placed in the wrong hands, your money could evaporate when a con artist wires it to a foreign bank account and gets on a plane to a country that has no extradition treaty with the United States. Or spends it on cars and fancy living, leaving you with losses instead of profits.
With whom should you deal, then? Ordinary investors should be cautious because they don’t have the financial wherewithal to recover easily from a setback.
Deal with the Known; Avoid the Unknown
Avoid handing your money over to unknown persons or organizations. While this may seem obvious, the SEC and other financial regulators have sued numerous fraudsters for making “cold calls” (i.e., unsolicited calls to people they did not know) to persuade unsuspecting members of the public to invest in fraudulent schemes. You know what we mean: the dinner time phone calls about get rich quick schemes like the finest ostrich farm you never heard of.
Con artists know how to make a good impression. They will be well-spoken and well-dressed. They will arrive in nice cars (which they probably bought or leased with other people’s money). They will have firm handshakes, look you in the eye and sound sincere. Their watches will be expensive, or excellent imitations of expensive watches. They will be personable and charming. If you’re not careful, you might end up liking them. But one moment of carelessness and you could lose thousands or tens of thousands of dollars.
Deal with people and organizations you know. This could include large national organizations with established reputations, or local firms. Either way, dealing with organizations and people you know significantly reduces your risks. They are easier to check out; and if something goes wrong, you may have an easier time resolving the problem. No one is perfect, and sometimes, someone you know will turn out to be dishonest. The people and organizations you know can sometimes surprise and disappoint you (ask Enron’s former employees about this) But your chances are better if you deal with a known quantum.
If you want to deal with a new person or organization, get reliable references, preferably more than one. Your cousin Herkimer, who hears of a different harebrained investment scheme every month--ostrich farms, prime banks, foreign currencies, penny stocks--doesn't count as a reliable reference. Get references from people whose opinions you can take to the bank.
Invest in an Asset, Not a Person.
Even when you are dealing with someone you know, you nevertheless must be careful. Some people may try to take advantage of your friendship and rope you into a bad deal. Or else, even if the person is honest, the investment may have faults your friend doesn’t recognize. The financial markets aren’t based on friendship. They are driven by commercial imperatives and economic logic. Make an investment because the asset has attractive qualities, not because the person selling it has attractive qualities. The profitability of an investment does not increase because a friend or neighbor recommends it.
Don’t be afraid of hurting someone’s feelings by saying no to their investment ideas—it’s your money at stake. You have no obligation to risk your money just to make someone else feel better. Don’t be afraid to admit that your investment goals are conservative. Your money is better invested in a passbook savings account than in the hands of a crook.
Government Sponsored Financial Insurance
In the financial world, you, the investor, bear many risks. However, there is some protection against loss. As you probably know, federal deposit insurance protects deposits at bank and credit union up to certain limits. This protection was instituted after the collapse of numerous banks during the Great Depression, to restore public confidence in the banking system. Federal deposit insurance insures bank and credit union deposits up to prescribed levels (basically, $100,000 per customer per institution, with money in retirement accounts insured up to $250,000 per customer per institution). Without deposit insurance, bank accounts would not necessarily be secure, as many of your grandparents or great grandparents found out the hard way in the 1930’s.
The assets in accounts with stock brokerage firms are insured to a limited extent. If the brokerage firm collapses, an organization called the Securities Investor Protection Corporation (SIPC) will replace the stocks, bonds and other assets in the account up to a limit of $500,000, with a $100,000 limit for the cash in the account. SIPC does not guarantee the dollar value of these assets (except the $100,000 cash coverage). If you had 100 shares of XYZ stock in your account when the brokerage firm went under, SIPC will give you 100 shares of XYZ stock whether those shares are worth more or less now than they were worth when the brokerage firm went under. In other words, SIPC does not protect you from the risks of the marketplace; it just protects you from the inability of an insolvent brokerage firm to deliver the contents of your account to you.
Other than federal deposit insurance and SIPC insurance for brokerage accounts, there are few guarantees in the financial world. That’s why it’s important to be careful about whom you entrust with your money.
Be very careful if a bank or credit union employee suggests that you move your money from traditional insured bank accounts like CDs, savings accounts and money market accounts into things like annuities, stocks, bonds, mutual funds, or college savings plans (like a 529 plan). You could unknowingly move money you thought was insured into an uninsured investment. Some banks station stockbrokers in their branch offices, who try to sell you investments that have no federal deposit insurance. Not all investments you can buy at a bank or credit union are insured. If you go to a bank or credit union in order to deposit money that will be federally insured, stick to traditional accounts like checking, savings, money market accounts (not money market funds) and CDs (or certificates of deposit). If an employee suggests that you put your money into something else, question the employee closely about the nature of the investment and whether or not it is covered by federal deposit insurance. Don’t confuse federal deposit insurance with SIPC brokerage account insurance, which does not protect the value of any stocks or other investments in your account. When in doubt, don’t invest, because you may inadvertently buy something you don’t understand. If the situation is unclear, leave and go to the next bank or credit union down the street.
Let’s now turn to our discussion of the proper foundation for building wealth.