When your stockbroker calls or meets with you to recommend an investment, there are a lot of things you ought to know before you agree to invest. Here are five questions you should always ask.
1. Why is this investment suitable for me?
Every investment a broker recommends must be consistent with a host of factors including your age, investment knowledge, objectives, financial circumstances, and the degree to which you are willing and able to take risk and withstand loss. You should make your broker explain why this recommended investment would be compatible with each of these suitability factors. If he can’t or won’t, he either hasn’t done the analysis or knows the investment is unsuitable.
2. What has to happen for this investment to be profitable?
In any investment, assumptions are made that some underlying financial asset — for example, a going business concern, a portfolio of real estate holdings, or a collection of debt instruments — will produce a stream of profits sufficient to both remain solvent and pay a return to investors. Ask your broker to explain what must occur to enable investors to be paid. If the broker can’t do that, he doesn’t understand the product well enough to be recommending it and you shouldn’t be buying it.
3. What is the worst-case scenario if I make this investment?
Like all salespersons, stockbrokers emphasize the good points of their products and downplay the bad. Don’t let your broker get away with just telling you what he or she thinks is “realistically” the worst that can happen. If there is a doomsday scenario, you need to hear it spelled out. Why? Because doomsday comes around plenty often on Wall Street.
4. How liquid is this investment?
Liquidity refers to the ease with which you can convert the investment to cash without incurring much loss in value. Ask the broker whether you will be able to get out of the investment if necessary. Sometimes the answer is “yes” or “maybe,” but only if you’re willing to incur some penalty or sell at a loss. Sometimes the answer is “no” because there is no redemption feature or because no secondary market exists. And if the investment can be turned to cash, ask how long it would take do so.
5. Are there any comparable investments that would cost less?
Your broker charges commissions when you invest, but there can be other transaction costs as well. Often the issuer and its affiliates charge internal fees and expenses, and the range of those costs can vary enormously depending on what you buy. Indeed, some investments carry such high transaction costs that you would have to earn double-digit returns just to break even and begin receiving profit. You should ask your broker to give you a break-even analysis or to at least explain and estimate each category of costs you’ll incur. You’ll also want to ask whether there are ways of achieving your investment goals with less expense. Remember: if both high cost and lower cost alternatives exist and there is no significant benefit to you from opting for the higher cost investment, your broker’s recommendation of the higher cost alternative would be unsuitable.