These rules are not all-inclusive; we welcome additional thoughts. Each of these rules is invaluable in protecting the trusting rich from the dishonest, incompetent or less-than-knowledgeable advisors, including accountants, bankers, brokers, financial planners, investment advisors and lawyers.
The first three rules should shield you from the most common frauds, as well as help provide you with legal protection. The remaining rules are important to safeguarding your portfolio from excessive risk.
Rule Number 1: “Pay Attention”
A. Perform due diligence on all new investments and their advisors.
B. Perform due diligence on all existing accountants, bankers, brokers, custodians, financial planners, investment advisors and lawyers.
It is perfectly reasonable to employ professionals to aid in conducting criminal and other background checks as part of your due diligence. At a minimum, you should obtain (a) a copy of all filings with regulatory agencies, including Form ADV—a public document that investment advisors registered with the Securities and Exchange Commission (SEC) are required to file and provide to clients; (b) three client references, and (c) copies of all letters to clients for the past five years. It is important not to rely on hearsay from the “country club set.”
Rule Number 2: “Don’t Trust Anybody!”
Entrust your assets only to a third-party custodian unrelated to your investment advisors and with whom you have a written agreement and receive a monthly statement listing the assets and their value.
Third-party custodians are typically trust companies that hold your assets and act as a go-between for your advisors and the brokers who execute the trades. Ponzi scheme/Madoff-type frauds are virtually impossible with this arrangement.
Rule Number 3: “Drive to Communicate”
Execute a written agreement with each and every broker, investment advisor, manager, or other professional. This agreement will fully specify your goals and objectives, and the investment products and strategies used to implement these goals and objectives.
Examples of investment products are domestic and foreign stocks and bonds; government, corporate or municipal bonds; options; exchange-traded funds (ETFs); commodity futures; mutual funds; investment partnerships (public or private). Examples of investment strategies include simply some suitable allocation to stocks, bonds and cash equivalents, based on your objective; a similar portfolio structure using mutual funds and ETFs; stock option writing (selling) programs; and short selling.
Rule Number 4: “Know when to Use your Headlights”
Require each advisor to present their fees for services showing the calculation and supporting documents that match the fee agreement in the investment advisory agreement.
Rule Number 5: “Connect your Mind to your Eyes”
Require your advisor to provide a monthly report showing total return, net of fees performance and comparisons to appropriate industry standard investment performance measurement methods and benchmarks. The monthly total return calculation includes all dividends and interest adjusted for additions and withdrawals of capital.
Rule Number 6: “Choose your Route for Safety”
Do not invest more than 2% to 3% of your net worth in any one investment or more than 15% in a group of similar investments (i.e. industry or sector).
Rule Number 7: “Always Signal Your Intentions”…in Writing if Necessary
Meet with each advisor (a) at least annually, (b) if you are concerned about your account performance, (c) if the securities purchased are not consistent with your written investment objectives or (d) if your investment objectives have changed.
Meeting with your advisors on a regular basis is important: It signals that you care about your account and the people who advise you. You should inquire about any changes in firm ownership, management and personnel and the reasons for these changes. If a large positive or negative divergence between your account performance and your investment objective occurs, you deserve an explanation. Perhaps the advisor took too much risk, or made poor security selections. Lastly, you should share with your advisor what is happening in your life that might affect your investment objective. Did you lose your job? Are you planning to retire? Did you have large gains or losses in other investments? Is a divorce looming? Are there family health issues? Are you in litigation?
Rule Number 8: “Look Down the Road”
Review your investment objectives at least annually and consider them to have changed if (a) your health has worsened, (b) you have a major loss of income from a job or investment turned bad, or (c) more than five years have passed since you changed your equity allocation.
The reasons for reviewing your investment objectives are pretty obvious, except, perhaps, (c). You should review your investment objectives if more than five years have passed since you changed your equity allocation because as you age, you have less time to recover from a catastrophic loss and therefore need to consider slowly reducing your portfolio risk. This rule does not apply to institutions.
Rule Number 9: “Know your Blind Spots”
Compare the monthly transactions and holdings statements from all investment advisors with the statements provided by the independent custodian.
Although this is largely a bookkeeping function, it is similar to balancing your checkbook. Confirm that your custodian holds (or no longer holds) in your account the same assets as the advisor’s statement indicates were purchased (or sold).
Rule Number 10: “Drive Precisely”
Value your marketable assets monthly and your non-marketable investments annually. Calculate your net worth annually after paying taxes.
Rule Number 11: “Avoid Distractions”
Value and review no less frequently than quarterly your assets at market and rebalance back to your investment guidelines if the difference exceeds 10%.
Valuing your assets at market at least quarterly makes you aware of the risk in your portfolio as indicated by the portfolio’s ups and downs. By comparing the market value of your portfolio segments (e.g. domestic equity, foreign equity, fixed income) with your investment objectives for these same segments, you can calculate where you need to reduce or increase your market exposure. This process is referred to as “rebalancing” your portfolio. A 10% difference between market value and objective is a reasonable but arbitrary trigger to rebalance.
Rule Number 12: “Buy and Use Safety Devices”
Purchase and maintain personal liability insurance, including legal defense. If you are a member of a board of directors, insist on Directors and Officers (D&O) liability insurance with legal defense.
Rule Number 13: “Know how to Recover from a Skid”
Purchase and maintain appropriate levels of property insurance and medical insurance for all immediate family members.
Rule Number 14: “Exercise Prudent Courtesy”
Do not guarantee debt, letters of credit, or sign recourse debt obligations for any business, family, friend, or third party.
Rule Number 16: “Maintain an Even, Measured Pace”
Endeavor to be completely debt-free by age 50 at the oldest, or sooner if in poor health.
Rule Number 17: “Never Play Chicken with a Train”
Never fund long-term illiquid investments with short-term borrowings.
This rule is designed to protect you from insolvency when your lender decides your collateral is no longer likely to be worth the loan value and calls the loan. This most often happens during a credit cycle contraction and/or business cycle downturn. Examples of typical long-term illiquid investments are raw land, developed commercial or residential real estate and private equity or venture capital commitments.
IGNORE THESE RULES AT YOUR OWN FISCAL PERIL, BUT BEWARE: THESE RULES WILL NOT SHIELD YOU FROM OVERPAYING FOR AN ASSET, SPENDING MORE THAN YOU EARN, OR YOUR OWN FOOLISHNESS.
* Rules adapted from “Drive Safe with Uncle Bob” by Bob Schaller accessed August 20, 2010 at:
http://www.roadtripamerica.com/forum/content.php?9
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