Due Diligence

Due Diligence
A Guest Article by James Grant

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Building wealth is not accomplished simply by taking a portion of your income and tucking it away in a mattress or the bank. Building wealth comes from acquiring assets that increase in value. If you were going to buy a house or a car you would not simply look in the classified section of the newspaper, find the best description that fit your needs and then call up and buy it sight unseen. Investing is the same process, you want to check the product out thoroughly and make sure it will suit your needs.

In investing the process is called Due Diligence. To say that you have completed the process means that you have assured yourself that you understand the mechanism of the investment, the risks of the investment, and the potential return of the investment. You can determine with confidence whether it fits your needs.

A lot of people invest in T-bills, mutual funds, or have a managed portfolio because they can't or don't want to go through the Due Diligence process. Some people simply decide based on the fact that these investments require little research for an understanding of them (T-bills for example). Or they do the process on the person or company that selects the investments rather than the investments themselves. Others do no Due Diligence at all and may someday have a rude surprise when they find that they have missed their investment goals by a wide margin.

If you don't want to make decisions for yourself about the sorts of investments your money goes into you need to find an investment professional that you can trust. The level of trust here is very high. You are essentially giving a person your money and saying: "Do the best you can for me!". This is the same as giving them the keys to your house and car.

Now you may have an investment advisor who you know and trust that well, in which case you have done your bit. But if you aren't sure abut a prospective advisor, there are resources to help you find out more about them and their company. The Investment Dealers Association of Canada has a good website and publishes accounts of disciplinary actions against members. Membership is not mandatory and it is worth asking whether your prospective advisor is a member.

Another website worth visiting is the TSE site, particularly their links page listing all sorts of organizations performing regulatory and watchdog activities on investments.

If you decide to make investment decisions for yourself, either because you are convinced you can do a better job (not as implausible as it sounds) or because you just can't see trusting someone or some company that much, you must perform your own due diligence.

There are several questions you must ask about each investment that you investigate:

What are all the risks of this investment
What form of return is this investment going to provide and what are the tax consequences of it
What is the mechanism of this investment vehicle (minimum investment, ongoing commitments of funds, penalties if you want your money out before you originally planned, commissions and other expenses, when is income paid out, what prerequisites and ongoing requirements do any possible tax incentives and tax liabilities have)
Does it fit into your overall financial plan

You may need to learn a little bit more about the mechanism's of the market to do this, but the reward, even for someone who is only investing a couple of thousand dollars a year, is well worth it. One of the best authors I have read explains the basic mechanics in one book and then more advanced ones in several others. Check out Peter Lynch's "Learn To Earn" for good basic investing information.

If you are thinking of buying shares in a Canadian company you will be happy to know that the regulations of all the exchanges in Canada require companies to file regular reports of their financial activities, activities of what the government considers major shareholders, and any business activities or decisions that would have substantial impact on the value of the company. All of these reports are available through the Internet at WWW.SEDAR.COM as well as all required reporting by mutual funds.

Due Diligence Dos and Don'ts (pardon the alliteration)

Don't, under any circumstances, put off doing the due diligence until after you have made the investment. Most people, if they do the process after buying, will exaggerate any positives they find and discount some of the negatives. It is far easier emotionally to not buy something than it is to say, "Oops I made a mistake I had better get out of this investment".
Ok, you've done #1, you bought 100 shares of ABC Inc. you are finished, right? Wrong. At least every quarter when ABC Inc reports its latest financial information check it out, make sure you are still comfortable with everything.
Don't react to the media. Newspaper, television, radio, your brother in-law, and worst of all the investment chat lines on the Net are not qualified sources of information. That does not mean to ignore any of them, but go to authoritative sources to check out what they say. The one reaction that is ok is to buy when you feel the company is doing every thing right but the market hates them for some reason.
Don't change horses too often. Keep your portfolio as simple as possible. Some of the best minds in the industry suggest that a good portfolio for someone with between $10,000 and $10,000,000 invested is 5 to 20 different investment vehicles. If you want more diversity than that you should be buying mutual funds or index funds, and count each one of them in that number above.
Re-iteration of rule #1, a good investment does not have to be made by any specific deadline (speculation may require it, but that is no different than trying to get your bet in before post time).

About the writer:

M. James Grant (Jim to his real world friends and Nadreck on the forums at Stockhouse, Yahoo, or here at About.com) is a part owner of a computer store/ISP/training centre/Network VAR in Yellowknife in the Northwest Territories.

M. James Grant in a rare suit appearance Like a lot of Canadians, he used to think that putting some money in an RRSP at the bank and owning a home and paying off the mortgage was the only way the average person could build a retirement nest egg. In the last 5 years he expanded his investing style to include a portfolio of equities outside his RRSP, mutual funds and equities in his RRSP and a managed RRSP portfolio in the Oil and Gas Sector. He is a student of the investing literature written by Nuala Beck, Gordon Pape, Faith Popcorn, Peter Lynch, Garth Turner, and Benjamin Graham among others. His investing philosophy in a phrase: "I am not afraid of risk in investments, just of not knowing exactly what the risks are."

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