Watch For These Red Flags Before You Invest In Stocks

A Few Red Flags You Should Know About

Published on:
October 28, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

Gordon Gekko could be easily identified. He combed his slick dark hair back; wore white
shiny suspenders; and certainly had an evil and malicious look. But to identify such sleazy characters in real life is not as simple.

I came across financial advisors, charged indicted and by the SEC, with crimes that ranged from insider trading to the creation of fraudulent financial statements, and some of them were the nicest looking people. 

 We need more than Hollywood characters to know which stock products or services to avoid.  BrokerCheck, by Finra is a website aimed to help you make informed choices about brokers and brokerage firms. But I doubt how many investors actually know of its existence and use it regularly to check on their financial advisors. 

The psychologist Jordan Peterson observed that most people take care of their dogs better than they take care of themselves; that most investors rarely investigate enough the custodians is an example of how little we take care of ourselves.

This meditation describes a few warning signals of bad financial advice.   

 Red Flag #1: Quick and Effective Cure-All

Just as there are no shortcuts to a happy life, there are no shortcuts to stock investing. To become successful at stock investing, you need to exhibit a stoic patience and to develop a long-term perspective. By definition, these qualities require time. 

And there is no single investing formula that will work in all economic cycles. What works when the markets are down will not necessarily be logical to follow when the markets are rising. How how you should invest in stocks in your twenties is not the same as how you should invest in your sixties. And if you are planning to sell your stock portfolio in three years or thirty years makes a big difference.  

 Red Flag # 2: A One-Size-Fits-All Formulas and Miraculous Breakthroughs

Except for the adage "Live within your owns," there are no axioms when it comes to stock investing. One investor may be comfortable in placing big bets on the direction of a foreign currency (imagine a George Soros) while another investor, who is just as skilled and smart, may be appalled by that investing strategy. Instead, that investor may focus solely on commodities such as gold (think James Grant).

 Not only is there no single formula for stock investing, logic dictates that if there was one, no rational person would share that information with you. When a business hires a consultant, he or she is expected to provide research. But it would be outlandish to think that the consultant is expected to explain to the business owner how to make a profit. 

Red Flag #3: Act Now!

"Necessity never made a good bargain,” said our founding father, Benjamin Franklin. And what was true over two centuries ago is relevant today. A wise investor compares among brokerage companies, assesses the possible outcome of a stock purchase and carefully analyzes the companies prior to investing in their stock. 

When a speaker for a commercial advertisement explicitly implores you to make a decision now, the speaker implicitly suggests that you should not think at all. And an omission of thought is one of the leading causes of accidents. The linguist Steven Pinker notes that "accidents are the fourth leading cause of death in the Unites States, after heart disease, cancer and respiratory diseases."  

 Red Flag #4: "Sophisticated" and Greek-Laden Language

Delta measures the degree to which a stock option is exposed to shifts in the price of the underlying asset. Gamma is the rate of change in an options delta per one point move in the underlying asset's price. And beta is a measure of a stock's volatility in relation to the market. And while these are interesting terms to explore if you pursue a doctoral thesis in finance, the prudent investor is better off to leave these terms to academia.

One of my pet peeves is the term "risk adjusted return," often found in a prospectus. What the authors of the prospectus mean to say is that they feel the expected return is adequate for the given amount of risk that they take. But an adequate return should be defined by the investor, not by the manager of a fund.

And so too should be the definition of risk. The American food author Michael Pollan suggested that we should not eat food that our grandmother would not recognize as food. His rule of thumb applies to stocking investing, too.  

Red Flag #5: A Claim of a Risk Free Investment

Marrying another person requires a leap of faith. Going through a medical procedure may have unwanted results. And when you invest in stocks, you may lose money. The term "risk free" is as real as the character Tyler Durden.

Instead of focusing on the sisyphean task of eliminating risk completely, what the investor should ask is what are the benefits compared to costs, and how the two weigh against each other. I argue that risk free investments are fairly tales. But the advisors who offer that schemes do exist in real life.


"Please let there be no strife between me and you, and between my herdsmen and your herdsmen," Said Abraham to Lot. "For we are kinsmen. Is not all the land before you? Please separate from me: if you go left, then I will go right, and if you go right, then I will go left."  

If you come across a financial advisor who claims any of the above mentioned red flags, my suggestion is to turn the other way and to follow Abraham's words.

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