Admitting what you don't know can be instrumental in improving your investment results.
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By Christine Benz | 07-25-11 | 06:00 AM | Email Article

"Nobody wants to be stupid. You know, once you're in the room with the Treasury Secretary or the CEO of a Wall Street firm or even just some hot-shot Wall Street trader, you don't want to seem like the idiot journalist who doesn't know what this is or why this works, because the natural response from the authorities is to ridicule you.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

But the obvious questions are usually really the best questions. So, like, the obvious question now? All right, Hank Paulson, treasury secretary, you just gave $200 billion dollars to banks to make loans, banks that have proven they were bad at making loans because they would be bankrupt without you giving them money. Why give them the money?"

Michael Lewis, author of The Big Short and Liar's Poker, on NPR's "On the Media," Nov. 21, 2008.

Lewis' point is an important one, and not just for journalists. Rather, his advice is sound for any consumer navigating the financial marketplace. Before you buy that quadruple-inverse Treasury exchange-traded fund, add a futures-based hard-assets investment, or pull the trigger on a large purchase like an annuity, make sure you ask the big, obvious questions first--of yourself or whoever is recommending the investment to you. And until you've exhausted all of your so-called dumb questions and understand in an excruciating level of detail the mechanics and the specifics of what you'll pay and what could go wrong, feel free to pass on that investment.

After all, the aim of any industry is to get people to buy stuff and spend money. Some of that stuff is terribly helpful--think antibiotics and irons that turn themselves off--and some of it, not so much. (Looking at you, electric martini shaker.)

The same holds true for products coming out of the financial-services industry, though I'd argue that the useful/usefulness ratio for financial products is even lower than is the case for other industries. In contrast to cars that we drive, clothes that we wear, or stuff that we use around our houses, most of us don't have hands-on experience with financial products, so we're not in a position to size up which financial products are likely to work well for us and which aren't. In turn, we might not even feel knowledgeable enough to ask the questions we need to make informed decisions.

So what are the best "dumb" questions to ask to ensure that you don't get talked into--or talk yourself into--a product that's useless or even harmful?

Here's a short list.

How Does It Work?
I'm not saying that you need to be able to get a job on a bond-trading desk to buy a fund that invests in Treasury Inflation-Protected Securities. But you should have a working understanding of  the basic features of TIPS bonds and their mechanics. You should know, for example, that your return will consist of a basic interest rate as well as an inflation adjustment, that the securities carry little credit risk but tend to be interest-rate-sensitive, and so on. includes reams of data about the performance and portfolio characteristics of individual investments, but before you find yourself venturing too far into the weeds, make sure you understand the basic premise and mechanics of an investment type first. And if you don't have the financial background to get your arms around how an investment works, you're much better off steering clear.

What Does It Do for Me?
In a related vein, make sure you're clear on what benefits the investment brings to your portfolio. Does it aim to increase your portfolio's growth potential or the amount of income it kicks off? Does it reduce the portfolio's risk/volatility level? (If an investment's main benefit is to diversify, it should also reduce your portfolio's volatility level.) Chances are an investment will purport to deliver on one (or more) of those three fronts, but the next question is whether there is a simpler or cheaper way to get the same type of exposure. You might, in fact, already have such an investment in your portfolio.

How Long Has It Been Around?
It's one thing to be an early adopter of electronics: If you buy a new type of smartphone or electronic tablet and don't like it, it's a disappointment but not a disaster. With financial products, however, the downside of venturing into a product that wasn't quite ready for prime time is much greater. Not only could you lose money or not receive the payoff you were hoping to, but you might also owe transaction costs to switch into something else. The financial industry is littered with product ideas that should've never seen the light of day, from the option-income funds of the 1980s to the Internet funds of the late 1990s to the overly aggressive ultrashort-bond funds that blew up during the most recent financial crisis.

Those investments--and their subsequent fates--provide a vivid illustration of why it's rarely a good idea to take a flyer on a product that sounds good on paper but doesn't have an observable track record--earned with real-life money, mind you, not theoretical money gained and lost via back-testing. Of course, there's no guarantee that an investment that has performed well in the past will continue to do so, but an observable track record lets you see how an investment has performed during several real-life market cycles and whether it actually has delivered the return, income, or stability characteristics you're seeking.

What Could Go Wrong?
Like the popular "Worst-Case Scenario" handbooks, it's worthwhile to explore exactly what could go wrong with an investment, even if its risk/reward profile has been beautiful in the past. Is there any possible scenario when the wheels would come off of the strategy, and if so, how likely is that? Once you understand the downside, you're in a better position to evaluate whether upside potential is adequate compensation.

What's in It for Them?
In addition to understanding how you'll make money on an investment--and how you could lose it--it's also important to think through how the company that's offering the product, as well as your broker or advisor, makes money on the deal. Do they earn a profit when you buy or sell, charge fees on an ongoing basis, or employ a combination of both arrangements? Does anyone have a vested interest in recommending one product type rather than another? Are their interests aligned with yours? What's a dollars-and-cents estimate of what you'll pay to own the investment during a 10-year time horizon? You may ultimately decide the costs are worth it, but knowing exactly what those costs are is essential to making that judgment.

See More Articles by Christine Benz

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Morningstar - 2011/07/25 - The Error-Proof Portfolio: Why the Best Questions Might Be the 'Dumb' Ones - <a href="">Christine Benz</a>
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