Introduction:
Anyone with any experience in making investments knows that running meticulous due diligence is the responsible thing to do, for their own peace of mind and because this is exactly what professional investors do. But more often than not, we’ve found that investors have their own very different ideas about what that process that should be, and more importantly how they know that they’ve done enough.
It takes a highly analytical and dispassionate frame of mind to go though this mill of “stuff to check”. For brave and detail-obsessed few, this comes naturally and the challenge is knowing when enough is enough. For many others, it feels like a boring and largely unnecessary chore that at best, they do because they feel they should.
But the truth is, when engaging in investment due diligence, thoroughness and attention to detail are paramount. With that in mind, it’s important to be aware of the common mistakes that can undermine the effectiveness of the process. By understanding these pitfalls, investors can take proactive measures to mitigate risks and make informed decisions. In this article, we will explore seven common mistakes when conducting investment due diligence, ranging from inadequate research to unrealistic assumptions. Additionally, we will discuss the importance of utilising checklists, addressing cognitive biases, and allocating effort effectively to maximise the evaluation process.
Without further ado, I give you seven of the most heinous due diligence blunders. Which ones strike a chord with you or maybe think you need to work on?
1. Ignoring Risks:
Neglecting to identify and assess potential risks associated with the investment is a common error. Risk factors such as industry volatility, regulatory changes, technological disruptions, and financial instability should be thoroughly evaluated. All these are external factors and outside of the control of the investment business, but how resilient is the company to these dangers over time?
2. Overlooking the Business Model:
Not fully understanding the investment’s business model can lead to poor decision-making. Whether it’s off-plan property, alternative investments, seed funding or dealing on the stock market, it’s important to assess the provider company’s revenue streams, cost structure, scalability, financial history and competitive advantages to determine its long-term viability.
3. Disregarding the Management Team:
Underestimating the importance of the management team is a common mistake. Evaluating their experience, track record, integrity, and ability to execute the business plan is essential to determine if they can effectively lead the company to success. When you’re presented with an investment opportunity, you’re often given a cursory description at best, and often promoting a “rose-tinted spectacles” view of the team. It’s usually short on detail and certainly won’t reveal any skeletons in the closet.
It’s so important to push beyond this and carry out your own careful background checks on the team. Hard-won experience shows that this element of due diligence is likely to be the most significant of all to the success of any investment where investment capital is locked-in for more than a year, and the longer the time commitment, the more relevant it becomes. Notable examples are Property Bonds (i.e. loan notes), major off-plan property developments & refurbishments and EIS company investments.
4. Not Using a Comprehensive Checklist:
Having no comprehensive due diligence checklist is a frequent due diligence sin. A checklist serves as a systematic guide to ensure that all important aspects of the investment opportunity are thoroughly assessed. Without a checklist, it’s easy to overlook critical factors or skip essential steps in the due diligence process. Creating and utilising a well-designed checklist helps to maintain consistency, ensure thoroughness, and minimise the risk of missing crucial information during the evaluation process. It provides a structured approach to investment due diligence and acts as a valuable reference tool throughout the decision-making process.
Another great benefit of checklists is when comparing two or more potential investments, as it makes life much easier in taking lots of complex detail to select the most appropriate investment for your present needs. Which leads us to …
5. Inconsistent Evaluation Criteria:
Failing to maintain consistency in the evaluation criteria when comparing multiple investment opportunities is another common omission. It’s essential to establish a set of standardised metrics and benchmarks to evaluate each investment consistently. This allows for a fair and objective comparison, enabling you to effectively assess the relative strengths and weaknesses of different investments. Inconsistency in evaluation criteria can lead to biased decision-making or overlooking key factors, making it harder to make informed investment choices. By maintaining a consistent framework, you can effectively compare and prioritise investments based on their merits, ultimately aiding in making well-informed investment decisions.
6. Unrealistic Assumptions & Ignoring Cognitive Biases:
Making overly optimistic assumptions or forecasts can lead to flawed investment decisions. Like it or not, this is human nature when we’re already attracted to an investment idea. It’s crucial to critically evaluate the underlying assumptions and assess their reasonableness based on market conditions, industry benchmarks, and historical data.
There are a whole raft of cognitive biases that cloud our objectivity especially when doing our own due diligence without any dispassionate independent help. It’s like marking our own homework. This is just part of what we call being “The Human Investor”: it’s pretty much impossible to completely eliminate them, but awareness gives us a fighting chance.
Cognitive biases are inherent mental shortcuts and patterns that can lead to irrational decision-making. Biases like confirmation bias (favouring information that confirms pre-existing beliefs) or anchoring bias (relying too heavily on initial information) can distort the evaluation process and lead to suboptimal investment decisions. It’s crucial to be aware of these biases and actively seek to mitigate their influence. Practice critical thinking, seek diverse perspectives from others, conduct thorough research, and regularly challenge assumptions, as these can help counteract cognitive biases and ensure a more objective and rational evaluation of investment opportunities.
Check out our post on Investing With A Clear Mind: Overcoming Hindsight And Outcome Bias.
7. Misallocated Effort:
Failing to identify and prioritise the key areas of focus during the investment due diligence process is a huge lost opportunity. It’s crucial to understand which aspects of the investment warrant more attention and resources based on their potential impact on the investment’s success or failure. This requires careful consideration of the investment’s unique characteristics, risks, and opportunities. By allocating effort and resources effectively, you can ensure that you thoroughly evaluate critical areas such as financials, market analysis, competitive landscape, legal and regulatory compliance, and management team, while not neglecting other important aspects. This targeted approach allows for a more efficient and effective due diligence process, enabling you to make well-informed investment decisions.
An important guide to targeting is the Pareto Principle (also known as the “80/20 Rule”), which tells us that 80% of the value of an exercise is gained from 20% of the effort. The remaining 80% is of value but it’s diminishing returns. So strictly allocating the right effort in the most significant places will keep your eye on the ball and avoid sucking your time and effort away from that all-important 20%.
Summing Up:
Investment due diligence is a critical step in making informed investment decisions. By avoiding common mistakes, such as insufficient research, disregarding risks, or overlooking the business model, investors can enhance their chances of success. Additionally, employing a comprehensive checklist, recognising cognitive biases, and focusing effort on key areas of evaluation contribute to a more systematic and objective approach. Remember, due diligence is an ongoing process that requires continuous evaluation and adaptation. By learning from these common mistakes and implementing best practices, investors can enhance their ability to identify profitable opportunities while minimising risks.
Let us help you on that journey.
