I like writing about making money off my investments. I bet you would agree that it is always more inspirational to make money, think about making money and write about making money than the opposite. But not all investments turn out positive, do they? So what do you do when an investment turns bad on you? Here are some things to think about doing when an investment turns bad.
One of my current investments is currently causing me a lot of headaches and, also, lots of potential legal fees. I’ve been grappling with it for the last 18 months and learnt a lot of insights around dealing with poor investments, that I’m going to share with you.
The antinomic thing is that the investment is currently very positive, from a short-term perspective and looking at net cash flows, thanks to one contributing factor; but if I don’t get things right soon, it can turn out to be a complete long-term disaster.
How it all started
This particular adventure started 2 years ago, and it began with the following proposition:
“I can help you wipe 200.000 $ off your personal income tax this year and help you acquire a 600.000 $ asset, at a 1.5% debt rate, that will generate a passive, guaranteed income stream that will build up over time from 6.000$ to 20.000$/year in 15 years’ time and also appreciate in value.”
Sounds pretty good doesn’t it?
Yes, it does.
Would you be skeptical?
I should add this was coming from a very reputable financial asset management company, listed on a European Stock Exchange and which works with some of the biggest private banks and institutional investors in Europe.
So, I did more research.
1. Always do your research and don’t rely on others to do it for you
The first thing I did was study the quantitative and qualitative information that the investment advisor shared with me. This is the base of understanding any investment, be it a stock on the market to a rental real estate purchase: do your research.
By that I mean read what you are given and make certain you understand it.
Understanding what you are reading or what you have been given means that you are able to simply explain it to someone who has no notion of investments. I have a few friends who are not particularly sharp on the investment side and they tend to be my yard-stick. If I can explain complex investments in a way they can understand, then I call that a win.
However, don’t only rely on what you are given. Look at collaborate studies, data, projections that can help you assess whether the information you have received is viable and makes sense.
I was able to get my hands on larger studies that confirmed the base assumptions included in the information the financial advisor had shared with me.
Seeing converging conclusions from separate data sources got me more comfortable that there was latent demand for the product I was buying and, also, good long-term growth potential. That’s essential when buying an investment. I also analyzed the tax regulations for this kind of investment to be certain the upfront tax benefit was real.
Another tool I use to understand investments is to build super-simple Excel models.
2. Build your own financial model – even a basic one
Though I detest Excel, I haven’t found anything better, so I still use it to model investments I’m considering. I don’t do anything complex. It is just about modeling cash flows and trying to establish various return indicators that can tell me if I make more money than I spend on the investment.
If I’m making more than I spend then that is positive.
The next step is to compare the amount I’m making against the money I would make if I put that money in a low risk asset, like government bonds.
Obviously, you want to make more than the low risk asset, but you need to assess the risk inherent in the investment you are buying.
3. Ask your ‘what if’ questions and model your potential downside
To model potential downside and risks, you first need to ask the ‘what if’ things go wrong questions.
Most of the time financial advisors don’t respond well to these questions and this was my experience on this investment. Everything was perfect, and nothing could go wrong. All the counterparts had strong balance sheets and cash flow.
I asked the ‘what if’ questions but couldn’t properly assess the downside. This was my first mistake.
I made some assumptions about downsides that were within acceptable ranges, but I didn’t go all the way to modeling a complete downside scenario. I didn’t ask the ‘What if a counterparty reneged on their contractual obligations?’ question that would prove to be essential in this particular case.
Could I have found more data in the fine print?
4. Read the fine print
All investments come with reams of data, even investing on the stock market comes with annual reports, stock analyst reports and the like. You don’t sign a contract as it is implied, but in my case I signed a contract. You need to read all the data to understand the intricacies of what you’re signing up for.
I read the fine print. But the fine print didn’t highlight all the things that could potentially go wrong. I assumed it would at least clarify the different counter-parties and their roles and responsibilities, but it didn’t and I didn’t go further.
I didn’t contact a specialist to get another point of view.
5. If in doubt consult with a specialist
Consulting with a specialist doesn’t mean spending loads of money on an outside firm looking at the fine print, building models and stress testing everything. Consulting with a specialist could be to discuss a project and to understand what are the usual things that can go wrong in the particular type of investment you are exploring.
With stock or bond investments, data is easily available and often speaking to a broker or experienced friend might be enough. With more unusual investments, it’ll be worth your while to speak to someone with more experience.
I spoke to my private banker, but that wasn’t enough. She didn’t have extensive experience in these types of investments. I should have spoken to an investment lawyer or another financial advisor firm to get a broader point of view.
I didn’t and it didn’t serve me well. This was my second mistake.
As I sit and write this, I think my complacency came from the time to break even – or in the case of this investment, which generated significant up-front cash tax advantages, the time that the cash upside up front was offset by the cash outflows.
6. Work out your breakeven point
When I modeled a downside case, without having all the probable downside scenarios, I simply assumed a case where the asset generated no cash inflows. I then looked at when my cash break-even was. It turned out to be 8 years. My conclusion was that within 8 years I would probably have the time to work my way out of the investment or that my capital growth would be enough to cover the future cash losses after 8 years. That would prove to be short-sighted.
Break-even analyses are important as they help you understand how long you need to hold an asset for and hence what time risk you are, by definition, taking on when buying the investment. Generally the shorter the breakeven the better.
I was too hasty in drawing conclusions from my break-even analysis. This was my third mistake.
When something went wrong, which in this case, did, the accumulation of my three mistakes caught me unawares and I was slow to react. It is important when things go sour to retrace your footsteps and do the things you didn’t do well in the first place to understand all the new factors that have come into play, so you can update your analyses and understand your risk and how to manage it.
7. Update your analysis when circumstances change
When the winds of my investment started to change, I relied on my initial financial advisor to steer me through it. As I hadn’t gotten a second opinion and as I hadn’t understood all the probable downside scenarios, it took me longer than usual to get fully up to speed and get a good grasp of the situation.
After a number of fruitless months, I realized finally that there was sufficient doubt and that not all the possible ‘what if’ questions had been sufficiently answered, that I finally turned to another specialist.
All it took was a 30-minute conversation to open up a series of further downside possibilities that I hadn’t considered, a few of which were now unfolding, and I was back to my model to figure out the financial implications.
Luckily the call also presented me with several remedies that I first tried to manage directly.
8. Try to first negotiate yourself if things turn badly Involve legal as a last resort
I do believe the best way to handle any negotiation is first to talk directly to your counterparty. This is always intended to get to know more and to work out how far the counterparty is willing to go to bridge any gap. In this case, this approach helped me understand better the issues of concern and the standing of the counterparty and what they were worried about.
I pushed the negotiation as far as I could and also “anchored” my financial request. I knew they would not accept it, given the discussions to date, but at least it set a negotiation starting point. I was hoping they would meet me half way and I wouldn’t need to involve lawyers but unfortunately this latter can’t be avoided at this stage.
However, before entering into direct talks, I had already evaluated the possible legal outcomes by a detailed review of their responsibilities as counter-parties.
Legal involvement should always be a last resort and you should never lead with lawyers when confronting a problem. I know this is cultural, but I’ve found, working in many cultures, that direct discussion can always open doors and help you understand more points that could be useful later down the line.
I’m now on the verge of sending out a first legal letter but as I’m comfortable with the counter-party responsibilities, I’m fairly confident I can reach a compromise in the next 6 months.
And most importantly, I keep advancing to resolution and protecting myself against further downside.
9. Don’t panic but don’t stop moving forward either
Not advancing is never a good option. Putting something aside and waiting for things to resolve themselves doesn’t work.
You don’t need to win the sprint as often your counterparty is running the marathon, so best to keep yourself moving forward at a slow steady pace. Slow and steady also means you have time to assess and digest new information, which saves you from having a knee-jerk reaction to something new.
Remember to update your models and keep assessing the impacts of changes to circumstances.
Knowing the current state of your bad investment is paramount to knowing when or if you finally pull the plug and lock in your loss.
10. Lock in your loss when you have no other options and move on
There may come a time when you run out of options to get your investment back on track and this time is usually when you have advanced as far as you can on the legal route and have no further options left to explore. Or it could be when the options to explore and the cost of those options outweigh the value you can get back from your investment.
When you get to the stage where the cost of maintaining or recovering your investment outweighs its current value then you need to lock in your loss and walk away.
Losing money is not inspirational. Losing money is not fun. But losing money can teach us valuable insights about making money. In this particular case above, I’m still in a cash positive situation and haven’t yet reached a situation where I have explored all my recovery or fix options but I’m also on the back-end of the timeline of 10 actions above.
The next few months will come with a clear understanding of whether I can get the investment back on track and get the counter-parties to come back to the table or whether I’ll need to lock in my loss and walk away.
Do yourself a favor, follow the first 7 steps with a lot of attention to detail so that you can hopefully avoid steps 8 – 10.