How to conduct due diligence before investing

Last week we explained how to know when returns are too high or too low because this allows you to detect fraudulent investment schemes. This week we continue the conversation with a related topic: "How to conduct due diligence before investing."

After assessing returns to know whether they are too high or too low, make sure they are also consistent with other characteristics of the asset such as risk and liquidity. 

For instance, an investment promising very high returns of, say, 5%+ above the risk-free rate cannot be low or zero-9risk. Indeed, there is no truly zero-risk investment on the planet. 

On this point, recall we mentioned that the 364-day treasury bill rate is around 10% last week. While the investment is low-risk because the government is credit-worthy, investors are bearing inflation risk because the return is below the inflation rate of around 18.1%. Inflation risk is the chance that the purchasing power of your investment will be weaker, that is, it will not be able to buy the same goods and services as before. 

The liquidity profile of the asset is also important. Liquidity refers to the ease with which an asset can be converted to cash. Cash is the most liquid asset because you do not need further conversion, neither do you incur transaction costs to access it. On a related note, stocks are generally more liquid than physical real estate assets because stocks can easily be sold as long as the market is open. Selling a property takes time. Even in stocks, some companies are easier to sell than others, and that is something to watch out for. 

Assets that are very liquid tend to offer less returns than illiquid ones of the same type because investors will demand for a premium known an illiquidity premium. So, putting risk and liquidity together, you should be able to determine return expectations. An investor will expect high returns when the asset is illiquid and high-risk, and low returns when the asset is low-risk and liquid. Inconsistency among these three indicators is a red flag that should cause you to be reluctant to invest or force you to ask more questions. 

Beyond understanding the risk, liquidity and return profile of the investment, also ask questions about the kind of the investment your money will be used for, the track record of the company, the promoters of the company, among others. 

Many of these investment schemes tell you the return you will get but do not disclose what the money is used for. Ensure you gain clarity on what they themselves are doing with the money before investing. This also means you can investigate and see if the returns promised are consistent with what the money is being used for. If someone tells you the money will be used for FX trading and says this is low risk by guaranteeing returns, you should know that this is fraudulent. Our advise here at MoneyAfrica is that you should never invest with people who will use your money as capital for trading. 

Finally, ensure you know the kind of people you are doing business with. For how long has the business been in existence? Is it regulated by appropriate authorities? Are the promoters of the company people of good reputation? Do they have a track record that is consistent with what they are promising? Getting answers to these questions will give you the much needed clarity to invest smartly.

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