A checklist to avoid bad investments

How do you define a bad or wrong investment?

Dhirendra: First and foremost, a bad investment could simply be an inappropriate investment. For example, you are investing for the long term and you have been advised to invest in something that is suitable for a short-term goal or the other way round.

Besides, there can be real toxic ones. I am talking about the rackets people land into. These investments are mostly too good to be true. For example, someone in your neighbourhood or acquaintance just comes and says that he has invested in something that will return 15 or 18 per cent. You get a sense of comfort, as someone in your circle has already invested and decide to put your money in it. But the thing is, the moment you get the assurance of a 15 to 18 per cent return, chances are you won't get your money back.

Sometimes, there are aggressive salespeople who have the incentive to sell a particular product. They don't understand your need and simply promote it - no matter whether it turns out to be appropriate for you or not. At times, they may even lie to you.

Dhirendra, I have often heard you saying that the impact of a wrong investment can be devastating. Why is that so?

Dhirendra: It is simply because you lose trust and then, stop investing in financial assets. And then, you get into investments that may be inappropriate but something with which you are more comfortable. Many people invest in real estate or gold because of the same reason. They feel comfortable with such investments, as they can see them for real, what they have invested in. They are tangible. They get the comfort that nobody can run away with it. But such investments are inappropriate for long term. Financial investments which give inflation-beating returns can translate into something really meaningful over a long period of time. They are also more liquid and have low transaction costs. They are more suitable for the requirement of the modern world.

So, how does one avoid getting trapped in wrong investments? Are there any warning signals that we need to be careful of?

Dhirendra: Normally, you can evaluate any investment by asking some basic questions. Simply enquire about the risk, return, liquidity and tax break. If it is very risky, it should yield a high return.

Do not simply believe in what you are told. Ask for evidence. It's your money and you have to guard it. If you don't get tangible answers to your questions, stay away. Don't sign the cheques in a hurry. Understand the product thoroughly.

What about chasing recent past performance or speculating? Should one do that?

Dhirendra: Chasing the recent past performance is a standard mistake that many investors do. When something goes up by 30 per cent, people think that even if it goes on a run for another six months, they may make 15 per cent if not 30. However, this often results in inappropriate investments. So, one should be methodical about his investments and avoid chasing the recent performance.

Speculation is a human instinct. All other forms of gambling are illegal. And everyone likes earning money easily. So, most of the time people get into the stock market and invest in a company without knowing much about it. They lack the information or skills. To my understanding, putting your money without having complete knowledge is gambling. So, don't invest your money in buying a business unless you have complete knowledge of it.

And what about diversification? You often tell everyone to diversify. How does it help?

Dhirendra: That is important. Even if you are not speculating and simply investing, things can go wrong. Every business has a risk. If you put all your money into just one, it will be vulnerable. What if something goes wrong. On the other hand, if you divide it among 10, all of them cannot go wrong. Your money won't be that vulnerable.

And if you think it is too much work for you, simply invest in mutual funds. Just be regular with your investments there and the rest will be taken care of.

What should one do if he is already stuck with a bad investment?

Dhirendra: That is actually the starting point in many cases, as most of the time, people start with something without knowing about it. Sometimes, it is the urgency to save taxes, say in February and March, and you simply invest in something that the salesman aggressively pitched. You just see that it is getting you a tax deduction and you invest without checking its appropriateness for you.

Ideally, one should understand the product before investing in it by asking those four questions. But it's never too late. If you haven't done that while investing, take stock of it now. Undo what went wrong. But don't blame yourself or lose hope. There is no point of losing hope as it will not lead you anywhere. You have to plan for your retirement and other essential goals if you want to be financially independent. Learn from your mistakes and continue investing.

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