Disclosure: This article contains affiliate links, which generate income for this free website at no additional cost to you. This article is written for entertainment purposes only and should not be construed as financial or any other type of professional advice.
Avoiding a bad investment deal can be as important as finding the right mix of investments. There are two main types of investing scenarios to avoid: 1) the investment scam, an outright illegal operation and 2) the raw deal, an arrangement that's legal but clearly not in the best interest of the investor.
The specifics of fraudulent offers and sketchy investments may change as times change. Today's environment may be ripe for tricks involving green energy or pre-IPOs whereas shady offshore investments may have been more prevalent in the past.
Sales pitches associated with out-and-out scams and lousy deals tend to be consistent. They may promise high returns with no risk or grant access to investments typically reserved for the ultra-wealthy. What's tricky is that they often contain an element of (half) truth.
If I decide to consider a specific investment or the services of an investment firm, it's up to me to deconstruct what's on offer and determine what's reasonable, what's misleading, and what's false. Here are common claims and how I approach them:
Promises of high, guaranteed returns
I may be able to get guaranteed returns with an FDIC-insured bank account or U.S. Treasury bonds; these returns could be 1% or higher, depending on economic conditions and prevailing interest rates. Historically, I've been able to generate higher returns by investing in stocks. So higher returns — especially over time horizons of 10 years or more — are possible.
Still, my stock investments (and other types of bonds like corporate investment grade, high-yield, and municipal bonds) carry risk. Price gains leading to relatively high returns are possible. But investments with potential for strong returns can easily lose money, particularly in an economic downturn.
In some cases, “returns” being promised are merely expected withdrawal rates. They'll last as long as the original balance can support the payouts, which could be a lifetime or just a few years.
So when I hear about guaranteed returns, particularly ones that are relatively high (5%, 7%, or more), I become skeptical. High returns can be produced, but never guaranteed.
Little-known stocks with huge potential
Investing in a profitable company that's undervalued and previously ignored by mainstream media can yield significant rewards. But just because shares of a little-known company can deliver great investment returns doesn't mean that all little-known stocks hold huge potential for profits.
In pump-and-dump schemes, con artists buy shares of little-known stocks when prices are low. They promote the company through investment newsletters, discussion boards, and other methods. Their efforts create demand, potentially leading to a significant rise in the stock price. When prices are high, scammers sell their shares and pocket the profits. When shares are no longer being snatched up by eager buyers, the stock price falls. Regular investors who bought shares are left with investments worth much less than their purchase price.
One way I've protected myself from losing money to little-known stocks is by determining a reasonable price to pay for shares. If I'm intrigued by a company referenced in an investment column, I'll conduct my own research. I'll review and analyze financial statements to estimate value, rather than relying on others who tout a stock's potential.
Investing opportunities sold by a friend of a friend
A friend or a referral from your professional or social network may be an excellent financial adviser. But simply being a friend or part of a trusted network doesn't guarantee trustworthiness or financial savvy. So it's wise to check out all potential advisers and scrutinize potential investments, regardless of the source of the recommendation.
Limited-time offers requiring fast action
In some situations, there are legitimate time constraints on investment decisions. For example, there's often a limited window of opportunity to snatch up bargains when stock prices fall as the result of some broader economic concern. Sometimes, I'm ready with the cash and information I need to make a smart buying decision. But oftentimes, I've put off my research and so decide against making impulse buys.
As a result, I know I've missed some great buying opportunities. But I've learned that new opportunities present themselves on a regular basis. So I never pressure myself to act quickly and I certainly resist being coerced into making a snap decision. Anyone who pushes me to jump on an investment is not the right adviser for me.
Investments reserved for a select few
It's true that some investments are accessible only to high-net-worth individuals and institutional investors. It's also true that these investments may have the capacity to deliver higher returns without adding significantly more risk. A simple example is Vanguard and its offerings of Admiral Shares with lower expense ratios but requiring a $10,000 investment (or more) compared to its Investor Shares at a slightly higher cost but with a lower minimum.
Similarly, certain investments may be offered to accredited investors only. For example, some real estate crowdfunding platforms require investors to have a minimum annual income of $300,000 or a net worth of $1 million.
But as a regular investor with average income or average net worth (or an income or net worth that hasn't been disclosed), being granted access to a special investment raises my suspicions. Being part of a select group should be based on having a certain level of financial means — including the ability to withstand losses — not that I've been handpicked as an easy mark.
Upfront expenses to get started with an investment
Getting started with a new investment strategy or new investment may involve some costs. Among these are capital gains' taxes and early redemption fees, which may be triggered when investments are sold in order to generate funds for reinvestment. Many investments carry purchase costs comprised of equity trading fees, sales loads on mutual funds, subscription fees to gain access to free trades, etc.
A competent adviser considers the big picture and may not fret over every penny. But not caring about or sloughing over investment-related expenses is dangerous. Advisers who don't care about my costs may be more concerned with increasing their bottom lines than growing my wealth.
Replacement of current investments with “better” investments
DIY investors may benefit from a portfolio review and update from a professional adviser. In this scenario, the adviser develops a model portfolio and asset allocation — based on the adviser's investment philosophy, portfolio theory, and the needs of the investor. Certain parts or all of the investments in the original portfolio are sold and replaced with investments aligned with the model one.
Replacement of current investments ought to accomplish specific goals. These may include closer alignment with an investment philosophy, lower risk, or lower expenses.
Sometimes, portfolio updates don't better align with the investor's goals. Instead, they may increase expenses, require longer holding periods, or reduce liquidity — while generating commissions for the financial adviser. Depending on the adviser-client agreement and frequency of trades, switching out investments without accomplishing meaningful and needed change is called “churning,” which is illegal.
When entertaining portfolio changes, I like to understand why recommended investments are better than the ones I've chosen.
Basic Steps to Consider When Evaluating an Investment or Investment Adviser
A few small steps may help avoid big problems. Here are some to consider these when reviewing the pitches and promises of financial sales representatives:
- Check out credentials using FINRA's BrokerCheck, its Professional Designations database (with links to certifying organizations), and the SEC's Investment Adviser Public Disclosure website.
- Determine whether an investment is SEC registered or whether you require such registration.
- Don't send money via wire transfer.
- Keep up-to-date on common scams by reading Investor Alerts and Bulletins at Investor.gov, Investor Alerts at FINRA, and Investor Alerts and Bulletins at the SEC.
- Understand that fraud or a bad deal can happen even when dealing with credentialed professionals who aren't technically scammers.
A big reason that I like to educate myself is to protect myself. Even if I rely on others to give me investing ideas or make investing recommendations, I'm still in charge of my money. Not losing money to scams, fraud, or lousy deals is essential to growing my financial success.