Stock investing for dummies
The Fraud Research Center estimates that Americans lose $40-$50 Billion dollars to fraud every single year, and up to 17% of the adult population falls victim to some form of financial fraud in a given year. Most of us believe that we’re too smart to fall prey to financial fraud, but successful fraudsters trick smart people out of their money by offering incentives that are just good enough to be true. In fact, the typical investment fraud victim isn’t a little old grandma who just learned to use the internet. Wealthy, risk-taking and educated males were ranked most likely to fall victim to investment fraud and scams in the Fraud Research Center’s 2012 study.
These are common investment scams that you should avoid whether you’re investing on your own or with the help of a broker. These overlap a bit with our other article on student loan scams – a lot of the same tactics are used – but this focuses exclusively on investors. A key takeaway with all these scams is that when it comes to investing, it pays to do research.
The Most Common Investment Scams
Here are the most common investment scams right now. You may recognize some of these.
Advance fee fraud happens when a broker or agent will request a fee to get you into a great investment that doesn’t really exist. Once a person pays the fee, the fraudsters move on, and you’ll never see your money again. Successful fraudsters mimic the language and persuasive strategies of legitimate commerce activity, so advance-fee fraud is difficult to catch, even for informed investors. One key predictor of advance-fee fraud is that the first contact comes from an unknown source via spam email. Spam email that comes through your junk filter will have an air of legitimacy to it, but it is possible to detect fraud. Most marketing emails explain investment offers directly in the email, but fraudulent emails offer only vagaries.
A well known version of this type of fraud is a request for money backing a “Nigerian Oil Investment.” Some of the spam emails you get about Nigerian Oil or Nigerian Gold are comically bad, but it’s important to remember that even smart people fall for well-disguised fraud.
If you’re the type of person who is open to a selling situation, or if you don’t mind taking risks, you should be especially careful to avoid this form of fraud. To avoid advance-fee fraud, you will need to do research on your own. A fraudster may offer social proof of other investors, or attempt to use “outside sources” to substantiate the legitimacy of their claim. They may even talk about risks. Before you buy any investment, research the company or investment that you’re buying into. Ask to look at business plans, and look into public records to see if the company has the assets they claim to have. While it is normal to pay a commission when you buy securities or commodities, it’s not normal to pay a fee before you have the chance to buy. In particular, being asked to wire money is a good indicator that the investment is actually fraud.
Internet investing fraud is common and growing phenomenon. In addition to Advance Fee fraud, the SEC warns about sources of investment fraud including newsletters and online message boards that promote pump and dump schemes.
Pump and dump schemes happen when promoters or insiders tout a particular stock to create the illusion of value. These fraudsters allow the stock price to rise before they simultaneously dump their stock on the unsuspecting public and walk away with millions lining their bank account. The Securities Exchange Commission warns that this type of fraud is particularly prevalent with Penny Stocks or Micro-cap stocks that don’t have to register with the SEC. Thankfully, the SEC offers specific guidance on how to avoid micro-cap stock fraud with a particular emphasis on how you can research micro-cap stocks on your own.
Stock pumping or juicing often comes through online investment newsletters. Online newsletters for investors can be a legitimate source of investing information, but fraudsters may attempt to increase the value of their stock or destroy a competitor’s stock through “unbiased” information in a newsletter. Securities law requires that investment newsletters disclose any time that they are paid by a specific company to tout the merits of that company’s stock. In particular newsletters may tout risky Penny Stocks (low priced and infrequently traded stocks) because they are being paid for it. Vague disclaimers indicate that the newsletter writers may have hidden intentions. The Securities Exchange Commission has guidelines for how you can spot newsletter scams, and they recommend ways to do research on your own.
Online bulletin boards also offer fraudsters the opportunity to make money by bolstering the price of small cap, thinly traded stock. Fraudsters may take to investing bulletin boards like those on Reddit under different aliases to offer and substantiate inside information about contracts, products, or mergers, and give the appearance of profitable investment opportunity. Before acting on the advice of online bulletin boards, it’s important to substantiate the claims on your own (either by contacting the SEC, or your state’s exchange).
As a general rule of thumb, it’s important to invest in stocks which you have thoroughly researched. I primarily choose to invest in individual publicly traded companies since I can substantiate claims on my I own, and I do my investing through discount brokerages like Scottrade or TD Ameritrade. If you do not have time or the desire to invest on your own, and you want to avoid scams, consider a robo-advisor like Wealthfront or Betterment. These companies invest in broad indexes, and won’t overload you on a single stock.
A Ponzi scheme is a form of investment fraud that uses new investor money to pay absurdly high rates to newer investors. Since the scheme relies on a constant influx of new cash it is impossible to sustain. For example, a scheme that promises to double your money would require an investment base greater than the population of the entire world after 35 rounds of investing. An investment that requires that you recruit other members is likely a Ponzi scheme.
The largest Ponzi scheme ever was run by Bernie Madoff’s scheme who stole $20 Billion dollars from more than 16,000 people including sophisticated investors and brokers. Madoff not only stole $20Billion dollars, he created another $45 Billion dollars in “paper returns” that never existed. Any investment that guarantees returns, or that has unrealistically high returns over a long period of time is likely to be a Ponzi scheme. You should also look out for investments in companies that don’t have an obvious source to generate revenue.
Prime Bank Schemes
Fraud artists lure unsuspecting victims into buying “prime bank” bonds in an overseas market. They promise huge profits, and they say they will split the profits between themselves and their investors. Most of the time, neither the products nor the markets exist. The tell tale sign that someone is attempting to fraud you with the prime bank scheme is if you cannot find information on the specific products on the internet. Fraudsters attempt to use secrecy to give their scheme an air of legitimacy, but no major bank sells financial products that need to be shrouded in secret.
Fraud artists may claim that their financial products are endorsed by the International Monetary Fund (IMF), the World Bank or some other international body. These organizations do not endorse financial products, and you can be sure that it’s a fraud if the seller makes these claims. If someone approaches you to buy international bonds, look into the product they are selling, and be sure it is real. If the product seems unnecessarily complex or too good to be true, it’s likely a fraud.
If you are interested in purchasing high quality international bonds you can research them through Moody’s or Standard & Poor’s credit rating agencies, and you can purchase them through discount brokerages.
Another Pseudo-Investing Scam To Avoid: MLM Companies
MLM companies (or multi-level marketing companies) are not all scams. However, many can be, and it’s important for investors in these companies to really know what they are getting into. Our good friend at Lazy Man and Money has an excellent article on spotting MLM scams, so check that out when doing your research.
In general, MLM companies want you to buy into their company through fees and by purchasing product at a “discount”. Your goal, then, is to resell that product to others and make a profit. However, many of these companies entice sales reps with bonuses for recruiting others. The scam companies are ones that perpetuate recruitment of new members to buy product, versus reselling product to consumers.
It can almost turn into a Ponzi scheme, where early recruiters and top recruiters make all the money, and the last ones to arrive to the company are left with product they purchased and can’t resell.
As such, be very cautious when doing business with any MLM company, even if they have a solid reputation. They might not be a scam, but it also might not be the right fit for you.
There are a lot of reputable investment companies out there. We compare all of the major investment firms here. However, there are also scam investment firms out there that prey on unknowledgeable individuals. Before committing any money to an investment, always do your research!
Readers, do you know of any other common investment scams? Know anyone who has fallen victim to one?
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– stock investing for dummies