Look Before You Leap: 10 questions every physician should answer before making an alternative investment

It reads more like a parable than a proverb: A friend or colleague approaches you with an "investment opportunity," you have some extra money available, and you don't want to miss out on the action, so you give him your hard-earned cash. And then something goes terribly wrong. You lose mostif not allof your money. Your relationship and your wallet both suffer greatly.

For example, consider this composite illustration that could happen (has happened, with variations on the theme) to any number of physicians.

 Look before you leap: An illustration

Dr. Brown and Joe, a well-respected local real estate developer, are good friends. One day, Joe offers the doctor a chance to invest in his next spec home. "It'll be my biggest project ever," he says, "and I've already got interested buyers. Your $200,000 will easily double.

Dr. Brown is intrigued. "The market" has given him ho-hum returns, so he has been looking for an attractive investment. Joe knows what he's doing, so the doctor shouldn't need to spend too much of his limited time inspecting the details closely. After all, his own house near the project site has appreciated nicely since he purchased it a decade ago. The next time they meet, a handshake closes the deal.

That was late 2007. You may already have guessed where this is headed. ("Spec," by the way, is short for "speculative.") Several months later, Dr. Brown has not heard much from Joe. Progress seems to be taking forever. By the time the home is completed, the bottom has fallen out of the real estate market; the interested buyers have disappeared.

Unable to sell the home, Joe moves into it himself. "We'll have to wait for the market to turn around," he says. Today, in 2011, Dr. Brown is still waiting.

The questions to ask

Bottom line: While there is a chance that you might get in on the next big deal, there's also a statistically greater chance that things will not go so well in an "alternative" investment (meaning an investment other than traditional stocks, bonds, and mutual funds). Before you put your capital at risk, ask yourself these 10 questions to increase the odds that you will receive a return OF your investment as well as a return ON your investment.

1. "Why am I being asked to make the investment?" The obvious answer here is because they need the money, with "they" being the people who are ultimately asking you to invest in their venture. But there's more to it than meets the eye. In a capitalist country like ours, there's a ton of money out there seeking excellent deals. What makes you so special that you have been tapped to tackle this deal? Is it your background and experience with similar deals? Or is it simply your availability (maybe even your naiveté)? Seek a convincing answer that stands to reason.

Don't be moved merely by the tempting exclusivity of a deal.

2. "How is the opportunity structured?" Most deals offer to make you a shareholder or a partner, while others may invite you to be a lender.

Some offer a choice. Your position will dictate your property rights which will determine your expected return, as well as where you stand in the pay-back line in the event of a debacle. Your position also gives you some idea about the offering party's motivation and a clue about how the deal will be handled. Along the spectrum from fully engaged partners to silent sources of cash, what sort of relationships do they seek?

3. "What will they do with my money?" If you are expecting them to be the stewards of your money, then you might want to know what exactlythey will do with it. Will your money be used to build a building? Or tide them over until more cash comes in? Or refinance an existing loan? Or develop a product? You want an answer that will tell you how they plan to create wealth with your money. If there are written materials available (like a business plan, prospectus, or private placement memorandum), you should dig through them to find the answers to these questions. Will they be providing ongoing reports, shareholder meetings, or similar ways to remain informed?

4. "How do I know they're telling me the truth?" When you judge the quality of an investment opportunity, consider the quality of the people involved with the deal. Are their names clearly disclosed? Confirm that they are who they say they are, and find out how long they've been doing what they say they'll do. It may be tempting to take someone else's word for it, but you should do your own homework to verify the offering party's credentials. Insist on a background check if you're not absolutely certain about their integrity. If you have access to an attorney or financial advisor to champion your interests, a small investment in an objective second opinion on the matter is money very well spent.

5. "What's my recourse if things go wrong?" Find out who you'll be dealing with when things don't go according to plan. Do they appear to be in a financial position to make you whole again? What does their backing look like? Is there any form of bond or assurance? While a risk is a risk, and you should expect some chance of loss, you want to know how things might wind up if the deal does not go as you hope it will.

6. "What are my alternatives?" While this particular deal might sound appetizing, there are always other deals, sometimes with better terms. Once you've been enticed to consider unconventional investments, you might find yourself in a whole new world as an investor.

Consider a range of options before selecting the ones that are a good fit for you. Focus on your real needs rather than the opportunity du jour.

7. "Do I really need to bear this risk?" Unconventional investments sometimes promise greater rewards than plain vanilla offerings like good old-fashioned mutual funds. By the same token, they usually entail a great deal more risk. Since many alternative investment opportunities require large sums of cash that may be tied up for some time to come, check the opportunity against your financial plan to make sure this risk is appropriate and necessary.

8. "How do I get my money back?" The liquidity of your investment is a good question, but even smart physicians often fail to ask about it.

The answer can be elusive. You may have more, less, or no control over when you can cash out. Perhaps your assets will be tied up until an initial public offering of stocks or bonds pays you out. Or maybe you'll receive your capital back in regular, periodic payments. Some investments may not be transferrable until your death (think "roach motel for capital"). If you don't need the money for a while, this may be fine, but it's best to go in with your eyes open.

9. "Could I lose more than I invested?" If you're being asked to buy a liability-generating asset (like equipment that will be leased) or if you become a partner in a business that goes belly up, you can end up in court or suffer spendy legal bills. Be particularly careful if you are being asked to guarantee a debt of the new venture (which is often the case with something as mundane as the development of a medical office building).

Don't assume that only your invested capital is at risk; sometimes an asset becomes a liability.

10. "What are the political risks?" When you put your capital to work, you may find that it competes with the interests of others close to you. For example, if you participate in a pharmaceutical venture, could you end up being perceived as having conflicts of interest? Or if you open a surgicenter that could be used to do procedures other than those of your specialty, might potential referral sources view this as a threat? Consider the value of your business relationships, family ties, and friendships "¦ and take the long view when you do so. These relationships may be more valuable to you than the money.

Revisiting Dr. Brown's situation

Let's return to Dr. Brown and steps he could have taken in considering Joe's proposal.

Why me? Had he probed Joe more carefully about why he was being asked to invest, Dr. Brown may have discovered that Joe was turning to his friends because he'd been unable to close a deal with his traditional funding sources. This might have been good to know.

What are the details? Dr. Brown also would have been welladvised to conduct some due diligence on his friend through an objective third party. He might have discovered, for example, that the reason Joe's usual creditors had turned him down was because he had never taken on a project of this size, and they lacked confidence in his expertise.

Don't skip the formalities.

Because Dr. Brown had no formal agreement with Joe, it was unclear whether his "investment" represented a loan or an equity stake, leaving the doctor with few property rights or legal recourse. Had he secured an attorney to define the venture, he may have been better positioned to recover a portion of his investment.

Think big-picture. If Dr. Brown had $200,000 of investable assets, was this the best use of his money given his own (not Joe's) personal goals? True, had he placed the money in a balanced blend of boring index funds, he would not have doubled his money. But he could have avoided the due diligence headache and captured market returnsplus he'd still have most of his capital.

Friends indeed. Had Dr. Brown demurred, citing any number of entirely plausible reasons ("My spouse says no," "My financial planner says no," "I need to upgrade my office equipment next year," "I'll be setting up a college fund for my children," etc.), he could have retained Joe's friendship. Or, had he lost it, it wouldn't have been much of a loss.

Instead, the friendship soured along with the venture.

When revisiting your hardearned money, remember what it's all aboutultimately, money is a means to an end. First, invest only as much as you can afford to lose without derailing your ability to reach your goals. Then, if you think you'll enjoy the experience of staking your claim and seeing whether you win or lose, do your homework, call your attorney, and go slowly. But if the thought of an "alternative" investment makes you nervous, then use that nervous energy to come up with a carefully considered plan and stick to it. Whether you bear a lot of risk or a little, be certain to have cash on hand when it's time to pay tuition bills or cover the cost of living when you're no longer in practice.

Mr. Utley helps young doctors get on track with a personalized one-page plan to get out of debt, save for college, and invest wisely for retirement.

This article originally appeared in the November 2011 print edition of Ophthalmology Business, pages 27-29. To download a PDF version, click here.