How to Identify and Prevent Investment Fraud
Some get-rich-quick schemes are too good to be true
By National Endowment for Financial Education | April 17, 2012
iStockphoto | Thinkstock
Be on the alert for investment fraud!
According to the U.S. Securities and Exchange Commission, the following investment scams are commonly used to target Americans:
- High-return or “risk-free” investments
Some unscrupulous brokers and investment advisers recommend unsuitable products that don’t meet the investment objectives or financial situations of investors. Inappropriate recommendations might occur when a broker sells speculative, high-risk investments such as options, futures, or penny stocks to individuals who are near retirement or are retired and have a low risk tolerance.
- Pyramid schemes
In this classic scheme, fraudsters promise sky-high returns in a short period of time for doing nothing other than handing over money and getting others to do the same. Despite their claims to have legitimate products or services to sell, these deceivers spend much of the money on themselves and simply use money coming in from new recruits to pay off early stage investors. Although the products sold may be legitimate, eventually the pyramid will collapse. At some point the schemes get too big, the promoters cannot raise enough money from new investors to pay earlier investors, and many people lose their money.
- “Ponzi” schemes
These are a type of illegal pyramid scheme named for Charles Ponzi, who fooled thousands of New England residents into investing in a postage-stamp speculation scheme back in the 1920s. Today, the Ponzi scheme continues to work on the same “rob-Peter-to-pay-Paul” principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses. Perhaps the most notorious Ponzi scheme came to light in 2008, when money manager Bernie Madoff duped investors out of $50 billion.
- Promissory notes
A promissory note is a type of debt that is similar to a loan or IOU and is used by a company to raise money. Typically, an investor agrees to loan money to the company for a set period of time. In exchange, the company promises to pay the investor a fixed return on the investment, typically principal plus annual interest. While promissory notes can be legitimate investments, those that are marketed broadly to individual investors often turn out to be nothing more than worthless paper. Most established companies have borrowing relationships with financial institutions, therefore this type of transaction among individuals is rare. Individual investors should exercise extreme caution with this type of investment.
- Internet investment fraud
Internet investment fraud is similar to other fraud perpetrated over the phone or through the mail. Fraudsters use a variety of Internet tools, including bulletin boards, online newsletters, spam or chat rooms to spread false information. They also may build a sophisticated Web page to make their scam appear legitimate. The Internet has made off-shore scams very easy to implement and difficult to police because the perpetrators often reside outside of the United States.
- Affinity fraud
This fraud refers to investment scams that prey upon members of certain groups, such as religious or ethnic communities, the elderly, or professional groups. Deceivers who promote affinity scams frequently are—or pretend to be—members of the group. They enlist respected community or religious leaders from within the group to spread the word about the scheme, by convincing people that a fraudulent investment is legitimate and worthwhile. Often, the leaders themselves become unwitting victims of the fraudster’s scheme.
How Can You Protect Yourself From Future Schemers?
To protect your investment, be sure to follow all five of these suggestions:
- Choose a money manager who is well-known, regulated by the Securities and Exchange Commission (SEC), and who has been in the industry for several years. Carefully examine testimonials you read or see advertised about a money manager.
- Beware any money manager who wants total control of all your money or who deliberately overemphasizes his trustworthiness and honesty.
- Choose everyday investments that can be bought and sold through well-known brokerage firms or mutual fund companies. Make sure your statements come from your brokerage firm, not the individual money manager.
- Make your checks out to your brokerage firm, not to an individual money manager or a company that person controls.
- Beware promises of high or unusually steady rates of return. If a money manager can’t easily explain his or her investment process, that’s a red flag.