Peter Lynch was famous for his stellar performance as manager of Fidelity’s Magellan Fund from 1977 to 1990. Over his 13 year tenure he was able to generate a 29.2% compounded annual return, compared to the S&P 500’s return of 15.8%. Very few people could top his success while he ran the Magellan Fund.
What Peter Lynch is also known for is his ability to take complicated topics and distill them down into simple terms. Quotes such as: “Never Invest in any idea you can’t illustrate with a crayon.” and “Invest in what you know.” illustrate his ability to teach basic investing skills to the masses in a simple manner.
Self Directed IRAs – invest in what you know
Investors should take these pieces of wisdom from Peter Lynch and apply them to their own investing plan. Self Directed IRAs as described in my earlier post The Self Directed IRA 101, are a great way to diversify beyond the stock and bond markets into asset classes that you know. If you are an expert in real estate, oil & gas, or private equity, then these are the assets you should focus on.
Investing in what you know could give you an edge over investing in areas that you are not as familiar with. However with opportunity and performance comes risk. Every investment carries a risk of underperformance or failure. That is the nature of investing.
Risks of Fraud with Self Directed IRAs
Performing proper risk management helps to mitigate these potential risks. One of these risks is fraud. The SEC, in its search to protect individual investors, has provided an Investor Alert, Self Directed IRAs and the Risk of Fraud, a few years ago to warn investors of the potential for fraud with Self Directed IRAs. In this alert, they discuss 3 common frauds and 5 ways to avoid these frauds.
- Misrepresentations regarding custodian responsibilities– This is the risk of a promoter or investment sponsor saying that because a custodian is willing to hold an asset, makes it “approved” and legitimate. In general, self directed IRA custodians explicitly state in their custody agreements that they have no responsibility for investment performance. Investors are responsible for their own investment choices.
- Exploitation of tax-deferred account characteristics– Promoters and investment sponsors can take advantage of the “long-term” nature of IRA investments by encouraging the investor to keep their money in it for longer than they might otherwise.
- Lack of Information for Alternative Investments– The SEC states that the lack of audited and transparent financial information, like with public companies, makes it easier to perpetuate a fraud scheme. While the SEC’s point is valid, in my experience many investors forego reading the disclosed and audited information provided by public companies. In addition, this availability of information in public companies is no guarantee of its validity. Waste Management, Enron, WorldCom, Tyco were all frauds leading to jail time for the perpetrators. The bottom line is investors need to do proper due diligence, regardless of whether the investment is publicly traded or not.
The SEC’s Solution to Fraud with Self Directed IRAs
The SEC also provided a list of five solutions to avoid fraud. While there are many ways to do proper risk management on an investment, this is a good start.
- Verify valuation information on self directed IRA account statements – The SEC’s solution is unclear on this point. They don’t provide a solution, but I will. Alternative investments held at self directed IRA custodians are required to be valued periodically, but no less than once per year depending on asset type. Each alternative investment has different approaches to valuations and must be provided by a third-party professional. If you are unsure about whether it is properly valued, consider speaking with a professional.
- Avoid unsolicited investment offers – Investors should be cautious when approached by a promoter. The SEC questions, “Why would anyone tell me about a really great investment opportunity?” Investors should certainly ask themselves this question. There are always people who take advantage of investor’s dreams of being rich. However it is realistic to assume that real people require capital to expand their business, rehabilitate houses, and come up with new ideas. If the investor is uncertain about an investment, then they should not invest. The world will not stop and there will be other investment opportunities available to each investor. Never get hung up on “the one great deal”.
- Ask Questions – This should be self-explanatory. Anyone who is considering placing money in an investment should do their own due diligence. This requires asking questions of all different varieties. Asking questions about the investment, management, the exit strategy, and the promoter of the investment. In many cases these people would be required to be registered or licensed in some way. Background checks can be helpful, and relatively easy and assessable via the internet.
- Be mindful of “guaranteed” returns – All investments have risk. This is the nature of investing. If an investment appears to have no risk, then you are not looking hard enough into it. Proper risk management is not about avoiding risk, but rather knowing what the risks are, mitigating them as much as possible, and being comfortable with what is left.
- Ask a Professional – The SEC suggests that investors get a second opinion from a licensed unbiased investment professional. Finding an Investment Advisory Representative who understands alternative investments held inside a self directed IRA is important. Investing in alternative investments inside Self Directed IRAs holds a different type of complexity than investments in public companies. Find a professional who understands this type of transaction.
Investors should always first look at how they can lose money in an investment before they look at how they can profit. Anyone who prioritizes risk management, and does it well, will save themselves a lot of headaches. If investors stick to what they know, they should very easily be able to illustrate it with a crayon.
If you want to learn more about Self Directed IRAs, Alternative Investments, or other related topics, read other contributions posted in Kirk’s column RIA Perspectives below:
Top 2 Reasons Investors Don’t Invest IRA Funds into Alternative Investments