How to Invest Wisely
Six tips to help anyone make sound investing decisions
March 16, 2009
Fred Foldvary, Ph.D.
Economist

The financial crash and recession of 2008-9 has wrecked the financial dreams of many investors. Those hardest hit had not adhered to the rules for wise investing. They concentrated their holdings in the hands of one trusted person, or they unknowingly took high risks.

An example of investment failure is the luxury condo-hotel in Baja California, Mexico, promoted by real estate developer and owner Donald Trump. Investors who had put large chunks of their savings into the $32 million project have sued him for restitution. All they money they had put in is now gone, as the project was abandoned, and all that is left is a big hole.

Investors made four errors. First, they thought real estate is always a good deal. Second, they trusted a big name. Third, they concentrated their assets in one place. Fourth, they did not pay attention to the institutional structure: being in Mexico, the project was subject to Mexican law, which the investors did not investigate.

The biggest investment disaster has been the Ponzi scheme of Bernard Madoff, who for many years was paying returns from new money that came in instead of from investment yields. Again, the investors’ error was trusting their money in the hands of one person and concentrating too much in one place. Another misplaced trust was in government regulation by the Securities and Exchange Commission. Companies are supposed to report to the SEC, but it had ignored warnings about Madoff.

Unfortunately, schools are not teaching the rules of investing. Governmental schools are supposed to prepare children for living in our civilization, but seldom if ever do they teach about finances and investing. There are many good books on finances, but many people don’t bother to read them, and even if they do, they often ignore the lessons.

The first rule for wise investing is diversification. Even cash is risky if there is higher inflation. Divide your investments into several classes of assets. Don’t put it all on real estate or in one project or company. Diversified classes can include stocks, bonds, real estate, cash, precious metals, and perhaps collectibles such as art, stamps, coins, and gems. Substantial stock holdings should be diversified among large and small companies, and domestic and foreign firms, and various industries.

Second, pay attention to the institutional structure. If you have a money manager, he should not be holding your money. The assets should be in the hands of a third party, such as a brokerage firm. The manager or advisor may direct where the funds are allocated, but not hold the funds in his name or account.

Third, be aware that investments are cyclical. If prices have been zooming up, this indicates coming trouble rather than opportunity. Stocks and bonds go up and down. Be prepared for a downturn. If you will need to spend the money within a couple of years, keep it in a low risk class, such as a certificate of deposit or in inflation-protected Treasury bonds.

Fourth, for long-term investment, have a long-term perspective. If you will not be using the money for 30 or 40 years, you can ride out the booms and busts. You will get a higher return from investments that fluctuate more. With continuous investments, you will buy more shares when prices are low and fewer shares when prices are high, which will add to the returns.

Fifth, gain from real yields rather than promises. Stocks that pay dividends to shareholders from their earnings will hold their value better than stocks in companies that have no profits now but expect to have them later, or which have profits but keep them in the company.

Sixth, beware of the taxman. Funds in a non-Roth IRA or 401k plan are taxed when the money is taken out. The worst case is an inherited IRA when the estate tax is paid from the IRA money and the IRA distributions are taxed as income. Suppose ten million dollars in an IRA are subject to a 50 percent estate tax. The $5 million tax comes from the IRA, but the $10 million distribution is also taxed as income, so if the income tax is also 50 percent, all the $10 million gets taxed away, and the heir gets nothing! A lifetime of investing all goes to the state. It would have been better if the IRA holder had paid the $5 million income tax and put the rest into life insurance, which the heir would get tax free. The IRA rule is: use it or lose it!

With many people now unable to make mortgage payments, firms are arising that promise to work with the lender to reduce their payments. Some of them ask for several thousand dollars up front. It is generally wise to avoid paying anyone all the money before the work is done. Legitimate firms will first make a deal with the lender, and then arrange for payments that are included in the new mortgage arrangement. Most mortgage payers are better off negotiating directly with the lender rather than pay someone to do this. If the lender refuses and you have a non-recourse loan, which means you can walk away and not be liable, then you have the clout.

These rules are common sense, but folks have to become aware of them, as it is easy to get carried away by a song and dance. The old rule applies: if a deal seems too good, it is probably bad.

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Fred Foldvary, Ph.D.
Economist

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.