Max & Beth
Max & Beth are a thrifty Canadian couple who have been wise with their money over the years. Happily married with children, they had paid off most of the mortgage on their $500,000 home (the balance outstanding is $50,000 on the mortgage).
A couple of years ago, after attending some workshops and seminars, they put their life savings into a couple of limited partnerships that invest in commercial and residential property. This included $250,000 accumulated in their retirement savings plan (called RRSPs – Registered Retirement Savings Plans – in Canada) as well as borrowing another $150,000 on their line of credit (secured by their residence).
The limited partnerships have run into various problems ranging from bankruptcy to fraud investigation by the government authorities. Currently, the limited partnerships are ALL frozen and may end up being worthless.
- Was it wise on Max’s and Beth’s part to pour all their life savings into these limited partnerships? Even if limited partnerships have been known to produce decent returns for investors in the past?
- Does the possible failure of these limited partnerships imply that middle class folks (MCFs) should NEVER invest their money into limited partnerships?
- What could Max and Beth have done differently if they had the chance to do it all over again?
- While the idea of exploring limited partnerships may have been wise, the ‘all or nothing’ approach of putting their life savings (plus borrowed money secured by their house!) into one investment vehicle was not only risky, but borderline suicidal. If they had succeeded, they may have made a killing, but a wealth builder needs to always evaluate both sides of the coin with a focus on ‘return of capital’ before ‘return on capital’. Protecting your principal should always be the first thing on your mind – if a bank offers 1% per annum on your principal, it may be a low interest rate but your $100 will become $101 at the end of the year (before taxes) so that when you find a better option offering 5% per annum, you still have access to the original $100. On the other hand, if you pull out the $100 and place it in another offer promising 20% per annum but the $100 ‘disappears’ or becomes $50, the promised 20% will leave you with less than your original $100. Relatively higher returns ALWAYS imply relatively higher risk – no exceptions. Knowing that the risks are relatively higher, there is always a need to hedge your bets – even when you succeed at highly speculative ventures (the type that can multiply your investment 1,000 times), it is always wise to redirect a significant portion of your windfall to more conservative investments that yield considerably less but are less likely to lead to disappointment. Plus, you should never allow your allocation of funds to a venture to exceed your understanding of, as well as risk management capacity for, the venture in question.
- The possible failure of these limited partnerships should not cause MCFs to permanently stay away from limited partnerships, just in the same way as bank failures do not cause us to stay away from banking products permanently. It should rather be an opportunity to learn about what went wrong and what needs to be done differently. Our (MCWB Club) approach is to ‘ease’ folks into these new types of investments. You may note that many of the partnership types that led to Max’s and Beth’s losses like to require folks to buy units in multiples of $10,000 or more. Are all such arrangements bad? Not necessarily. But if an MCF knows they have limited resources, they should ‘step into the ocean with only their toes’ for a start rather than diving in. If you are not a swimmer, stepping into the ocean with only your toes means you have a high probability of running away from a sudden tide. A deep sea diver on the other hand can dive in and if a tide sweeps them away, they know how to follow the wave to sea and work their way back after the wave has calmed down. If Max and Beth had put not more than $5,000 (2% of their retirement savings) into these partnerships for a start, it would have afforded them an opportunity to understand the pitfalls as well as possible rewards associated with that option, in a less threatening way. Even if they lost $5,000, they wouldn’t be wiped out. The focus is not to prevent losses (otherwise you would have to keep your cash under the ground in a hole) but to make sure that the cost of losses do not exceed the benefits (lessons). Losses are learning opportunities to make us better.
- What Max and Beth need to do is to watch out for red flags – refer to our Fraud Prevention resources and note the bullet points below:
- Anyone who encourages you to put all your life savings into one vehicle (in this case, limited partnerships) as well as encourage you to even borrow is not likely looking out for you as much as for themselves – especially when these cheerleaders are the ones promoting the investment vehicles in question.
- There is a need to make your investment decisions in a ‘detached’ environment. It is good to attend free seminars and all, but you need to ‘sleep’ over whatever you hear and get a trusted (unbiased) second (possibly third and fourth) opinion. Also focus on these tips.
- You need to figure out whether there are any oversight/verification arrangements by independent third parties (external audits, appraisals and so on)
- Is there an independent custodian for the investors’ funds? So that when investors part with their money, there is at least another independent party to ensure that the money is used in accordance with the investors’ expectations. A pyramid (also known as Ponzi) scheme cannot succeed if a reputable, independent third party custodian is in the picture.