Investing scams have a long history. In 1919, as the stock market began to fall, an Italian immigrant named Charles Ponzi claimed to strike gold in international postal-reply coupons. Prices of postage varied from one country to another, so there appeared to be an arbitrage opportunity — buy postal coupons abroad, where they were cheap, and redeem them in the United States, where they cost several times as much. Ponzi started advertising his services, promising investors a 50% return in as little as 45 days.
Problem was, Ponzi didn’t pay off his investors with actual profits. He paid them with the money from other investors. When too many people tried to cash in at once, the scheme collapsed. Victims were lucky to get back 30 cents on the dollar. Asked to explain his actions, Ponzi reportedly said, “The public deserves exactly what it gets. No more, no less.”
Ponzi’s words may seem cruel and remorseless, but there’s an important lesson here: The only person you can really count on to protect you from bad investments is you. In today’s tough market, people are more eager than ever to find safe ways to make and preserve money. But that also means we’re more susceptible to pitches that seem — and often are — too good to be true.
These “opportunities” may range from outright fraud to a legal financial product whose chances of success are stacked against you.
Here are some telltale signs of an investment rat and what you can do to pick up the scent — before you become a victim:
Investment Scam #1: It’s Guaranteed
Guarantees are beguiling, and a typical tool in investment scams. Get the profits you want, minus the risk you fear. But a guarantee is nothing more than a promise, and a promise is only as good as the integrity of the party making it. Scammer R. Allen Stanford lured 30,000 customers to place $8 billion of “certificates of deposit” with his Antigua-based Stanford International Bank. His bait? Abnormally high interest rates, often double or triple what stateside banks were paying on the same maturities. However, Stanford’s bank wasn’t insured by the FDIC, and its books were audited by a tiny Antiguan accounting firm. Stanford insiders, family and friends dominated the bank’s seven-member board. Surprise! The bank’s guarantees turned out to be worthless.
Just as important to look out for are uncannily smooth returns, which give the implication of a guarantee. Stanford’s bank told customers it had earned investment returns between 10.3% and 15.1% every year from 1995 through 2008 — despite two severe bear markets for global equities, and a historic downturn for real estate, during that period.
Bernie Madoff, whose own scheme came to light in the midst of the 2008 financial crisis, didn’t outright guarantee wild returns. Instead, he fabricated account statements to show a more modest but impossibly consistent return of about 1% per month even when the market tanked. “Too smooth” is a red flag with investments as well as people.
Investment Scam #2: Free Lunch
Come to a free investment seminar, meal included — nothing will be sold to you! More than likely, if you haven’t already received such an invitation, you will. According to the FINRA Investor Education Foundation, as of 2010, 78% of seniors are targeted by these tactics, with 60% receiving six or more invitations over just three years. In fact, however, these seminars are nothing but a sales pitch in a fancy wrapper.
In September 2007, a consortium of regulators issued a report about a year-long examination of 110 such “free lunch” seminars. They found that 100% of these “educational workshops” were sales presentations, half made misleading or exaggerated claims and about one-third either pitched unsuitable products or committed outright fraud.
Bottom line: Use your common sense. The hotels, resorts and country clubs where these seminars are held aren’t free, nor are the meals. They have to be paid for somehow, and ultimately, the money comes (in the form of fees) from the pockets of the attendees. Stay away, unless you’re a master at saying “No!”
Investment Scam #3: I’ll Make You More Money for ’2-and-20′
Everybody these days, it seems, either wants to get into a hedge fund or wants you to get into one. Only open to high-net-worth investors, these partnerships generally aren’t registered with the SEC and therefore aren’t required to follow the same rules as mutual funds. The real problem, though, is the fees hedge fund managers charge: typically, up to 2% of assets (per year) for their services, plus as much as 20% of any profits.
Supposedly, in return for these fees, a hedge fund will be able to score positive returns in any market — a tempting offer. But do these folks actually deliver? Industry-wide figures are hard to come by, and notoriously unreliable (because bad hedge funds quickly go out of business). However, the London Daily Telegraph cited a stark example of just how damaging 2-and-20 fees can be even with the best of performance.
Warren Buffett is widely regarded as one of the greatest investors of all time. A $1,000 investment in Berkshire Hathaway when Buffett took over the company in 1965 would have grown to $4.8 million through 2009. On the other hand, had Buffett charged the 2-and-20 that hedge fund managers do, that same $1,000 would have grown to only $400,000. In other words, $4.4 million that could have been yours would instead line the pockets of the hedge-fund manager.
Avoid any hedge fund with this top-heavy fee structure.
Investment Scam #4: Rare Coin Ripoffs
I’m a believer in rare coins — selectively and carefully accumulated for an inflation hedge. If you’ve listened to the radio or watched cable TV lately, however, you’ve probably heard some suspicious coin ads. Often, these “collectible” coins are marketed by companies whose names include the word mint, even though the fine print admits they’re not affiliated with the U.S. Mint.
For example, the New York Mint has advertised “the largest Morgan Silver Dollar hoard we’ve seen in decades,” offering each coin for $89. The ad copy was peppered with words like “rare” and “fortune.” Sounds great, right? Unfortunately, you can buy the same coins for about $42 to $52 from other dealers, and even less on eBay.
If you’re in the market for Morgans, check first with a low-cost dealer like Liberty Coin Service in Lansing, Mich. (800-527-2375 or 517-351-4720), a firm I’ve recommended for more than 25 years.
Four Tried-and-True Principles
While scams and high-pressure sales pitches take many forms, and their constant shape-shifting can make it difficult to tell an opportunity from a trap, here are four principles I put to work in my own research. They’ll help keep you from being eaten alive by the rats:
- Trust no one without verifying their claims. I mean nobody — not only strangers, but also coworkers, family members and friends. A simple way to get started is to search the Web for the proposed investment, accompanied by words like scam, hoax, fraud, ripoff, etc. Searching the Web takes only seconds, but it can quickly lead you to law-enforcement reports, testimonials of scam victims and critical reviews of purported investment opportunities. For a primer on determining who is a legitimate investment adviser, rather than a huckster or a fraud, visit http://www.sec.gov/investor/brokers.htm.
- Beware claims of urgency. Their sole purpose is to get you to act before doing your due diligence. As Warren Buffett likes to say, “If it’s a good idea today, it’s a good idea tomorrow.” Sleep on it to avoid making a hasty decision, and do your homework in the morning — away from the promoters.
- Cast a skeptical eye on “secret” clubs or groups. Nothing makes a scammer more uncomfortable than scrutiny, and an easy way to avoid it is to surround the scam with an aura of exclusivity, which both massages the egos of its victims and prevents them from spilling the beans to someone who will see it for what it is.
- If it sounds too good to be true, it probably is. This is the bedrock principle that underlies all the others. Never forget it! Far better to miss a few legitimate opportunities that sound a little outlandish than to fall for the one bad idea that devastates your portfolio — and sets you back for years, or even decades, on achieving your financial goals.
Billy Currano assisted with the research and writing of this article.