Top 5 Investment Scams and How to Avoid Them

Written by: Brad Zimmerman

Investment scams can be devastating to an investor’s bank account and financial future, and nearly one in five American adults have fallen for an online scam, according to a study released this year by Harris Interactive. Losses are rarely recouped, making it important to recognize a scam long before committing any money.

Here are five of the most popular investment scams and some ways to avoid them:

1. Ponzi schemes

The Ponzi scheme is simple enough: the scammer gets money from investors by promising big returns and pays the early investors their promised returns with money from later investors. In this way, the creator can lure in new word-of-mouth investors, as well as get current investors to invest more money. The scam can operate as long as new investors keep buying in, which eventually slows, initiating the scheme’s collapse. The orchestrator of the Ponzi scheme has usually taken most of the money brought in and remains the only person with any profits left after the scheme has fully collapsed.

In Malaysia and Singapore, a recent Ponzi scheme promised 300 percent returns in 15 months—an average 25 to 45 percent per month—for an initial investment of just $1,000. The money was supposed to be put into commodities but was busted as a scam, according to TodayOnline.com, a Singapore news website.

Ponzi schemes offer promises of high yields with quick returns and sometimes mention “getting in on the ground floor.” The hook for a Ponzi scheme lies in the scammer never actually investing the money the way it was supposed to be. If an investment opportunity offers returns well above the average for that industry, it should raise a red flag for investors, who should then conduct due diligence with more detail and depth than usual. Rates that are too good to be true typically signal a scam or inexperienced company. Investors should always consult accredited financial advisors or other trusted sources before jumping in head first. Also refer to the next section for ways to verify the business and the individual offering the investment.

2. Unregistered investment products and unlicensed selling of securities

Both securities and the people who trade them must be legally licensed. It is possible for accredited investors to purchase certain unregistered securities. However, these individuals are expected to have the knowledge to evaluate the offerings sufficiently and the financial resources to stomach any losses. If investors do not qualify as accredited, they are subject to strict rules, as are the companies offering the investment.

If you are not an accredited investor and get solicited for an investment, this should trigger a red flag as a potentially illegal solicitation (see the section dealing with accredited investors in our article on Other People’s Money). Unregistered investment schemes typically involve language such as “limited or no risk” and “high returns” by investing in viatical settlements—when a life insurance policy owner sells the policy before it matures—promissory notes or other unregistered securities. Unlicensed sellers will typically sell unregistered securities and promise large returns in the process.

Investors should be sure to research all securities and security sellers before investing. This can be done by contacting a state securities commission or the Securities and Exchange Commission (SEC). It is also important to be wary of the word “exempt” when a seller or security is listed as offshore; it may be another way to avoid the accountability provided by registering a security. While not all offshore sellers or securities are scams, researching these companies is often much more difficult. Unless an investor is familiar with that country's laws and regulations, it may not be worth the additional risk.

3. Promissory notes

When used legitimately, this type of loan or IOU revolves around an investor loaning money to a company in exchange for a fixed return on the investment, such as principal plus annual interest, according to the SEC.

“Bear in mind that legitimate corporate promissory notes are not usually sold to the general public. Instead, they tend to be sold privately to sophisticated buyers who do their own 'due diligence' or research on the company. If someone calls you up or knocks on your door trying to sell you a promissory note, chances are you're dealing with a scam,” according to the SEC.

Scammers will generally offer investors high fixed rate returns and low risk on promissory notes with little or no intention of ever paying anything back. Investors should think twice about short-term promissory notes offering above-market rates.

Selling promissory notes requires a license, as promissory notes are considered securities. Investors should contact local or national securities commissions to research licensing issues before investing. Scammers may also manipulate unlicensed and unknowledgeable life insurance agents to sell promissory notes to investors on the promise of high commissions. Many times these notes will be for companies that do not even exist, so it is also important to question the knowledge and reputation of the note’s seller.

4. Internet frauds

The Internet is an increasingly popular way for investors to do research and make investment decisions. Learning to sort the real from the fake is step one in avoiding fraud online. Phony newsletters touting unknown or unregistered securities, advice on message boards and links in junk e-mail are all ways that the Internet can mislead investors. The best advice is to be cautious and use trusted sources when looking for investment information online.

The SEC encourages investors to consult its EDGAR Database for official audited financial reports on all companies with more than $10 million in assets and those listing securities on the NASDAQ or New York stock exchanges.

Con artists often prey on ethnic or religious groupsThe Internet has also spawned new twists on old scams. Investors are encouraged to meet with partners in person rather than just online and to verify information using multiple sources.

5. Affinity frauds

Con artists commit affinity fraud by preying on those with similar backgrounds, especially ethnic or religious backgrounds.

One man used ethnicity to defraud a group of Korean Americans in California out of as much as $36 million. He had promised to invest their money in brokerage accounts at a registered brokerage dealer; he was eventually busted for storing the money in personal bank accounts, according to California’s Department of Corporations.

Affinity fraud plays largely off the trust of group members in one of their own. Scams commonly involve a few group members who make a pitch to the rest of the group, banking on the trust that the group has in them.

It is important to be skeptical of testimonials and names used by a seller and to always review the investment on paper before committing any money, according to the North American Securities Administrators Association. Members of a similar religious or ethnic group should receive the same diligent review as anyone else offering to handle your money.

It is important to remember that investors can easily avoid fraud by spending a little extra time verifying the validity of all potential investments. It is rare for an investment scam to pass a thorough due diligence process. If all else fails, common sense may serve a skeptical investor best: If something seems too good to be true, assume it is until proven otherwise.