In investing, what you don't know can hurt you. Due diligence—the careful investigation before committing capital—separates informed investors from those who learn expensive lessons.
Why Due Diligence Matters
Every investment involves a degree of uncertainty. Due diligence doesn't eliminate uncertainty—nothing can—but it helps you understand what you're getting into, identify potential problems, and make decisions with open eyes rather than blind hope.
The depth of research should match the stakes. A small allocation to a diversified fund requires less scrutiny than a significant investment in a single company or alternative asset. But some level of investigation is always warranted.
The Basic Framework
1. Understand what you're buying: This sounds obvious, but many investors can't clearly explain what their investments actually do. Can you describe the business model? Where does the money come from? What creates value?
2. Examine the track record: Past performance doesn't guarantee future results, but it provides useful information. How has this investment performed across different market conditions? How does it compare to alternatives?
3. Analyze the risks: Every investment has risks. The question is whether the potential rewards justify those risks, and whether you can afford to bear them. What could go wrong? What happens in worst-case scenarios?
4. Evaluate the people: Who manages this investment? What's their experience, incentive structure, and reputation? In some investments, management quality is the most important factor.
5. Check the fees: What does this investment cost, both explicitly and hidden? How do fees impact long-term returns? Are there cheaper alternatives that accomplish similar goals?
Where to Find Information
Official filings: Publicly traded companies file detailed reports with regulators. Funds provide prospectuses and annual reports. These documents are often dry but contain crucial information.
Third-party analysis: Rating agencies, research firms, and financial publications provide independent perspectives. No source is perfect, but multiple viewpoints help build a complete picture.
Industry context: Understanding the broader industry helps you evaluate whether an investment's claims are realistic. What are industry norms for profit margins, growth rates, and valuations?
Competitive analysis: How does this investment compare to alternatives? Why choose this over competitors? What advantages does it have, and how sustainable are they?
Red Flags to Watch For
- Pressure tactics: Legitimate investments don't require urgent decisions. "Act now or miss out" is almost always a red flag.
- Guaranteed returns: No legitimate investment can guarantee returns. If someone promises specific outcomes, especially high ones, be very skeptical.
- Complexity as a feature: Some investments are necessarily complex, but complexity is sometimes used to obscure problems or justify excessive fees.
- Lack of transparency: Reputable investments welcome questions and provide clear information. Evasiveness about fees, risks, or mechanics is concerning.
- Too good to be true: High returns with low risk don't exist. If an investment claims to offer both, something is wrong.
The Ongoing Process
Due diligence isn't a one-time event. Circumstances change, new information emerges, and your own situation evolves. Periodic review of your investments ensures they still make sense given current conditions.
Key Takeaway
Never invest in something you don't understand. The depth of research should match the size of the investment, and due diligence is an ongoing process, not just an initial step.