If there's money involved, there will be people who try to scam you. They know that many investors are looking for quick gains and they'll try just about anything to cash in. How can you keep from being a victim of these five investment scams? Read below to find out.
TUTORIAL: Investment Scams: Introduction
Distressed Real Estate
When the housing market is under pressure, there are always people who want to purchase foreclosed homes in bulk and they go looking for investors to finance that venture. Although this isn't necessarily a fraud, these baskets of distressed properties have to be registered with the state securities agency. There are many stories of individuals collecting money from investors and attempting to keep the money for themselves.
If you want to invest in distressed properties, purchase a property yourself or invest in one of the many investment products already on the market. Ask your wealth manager if you're eligible to invest in collateralized debt obligations or another other mortgage-backed securities product. (For more on collaterized debt obligations, see CDOs And The Mortgage Market.)
Boiler Room Scheme
Quality investment opportunities don't come to you. In nearly all cases, you go to them. (Unless you have a very high net worth.) If you receive a phone call asking you to invest in a company that isn't yet public but will be soon, it may be a boiler room scheme. If you agree to purchase the stock of this soon-to-be-public company, they will tell you to wire the money to a certain bank account and the stock certificate will be sent to you. Of course those certificates never arrive.
There's a modern day gold rush going on in North Dakota where it is estimated that 4 billion barrels of oil are in the ground. Using a method known as hydraulic fracturing or fracking, oil companies can extract oil and gas from shale that is two miles underground. This method of extracting oil is extremely costly and commonly taken on by the largest energy companies, most of which are publically traded. Although investing in an energy startup isn't always a scam, with the amount of publically traded energy companies as well as exchange traded funds holding baskets of energy stocks, investors who wish to invest in energy can do that within the safety of a publically traded company. Investing in private companies is much more dangerous than purchasing publically traded stock.
Pump and Dump
You receive an email telling you about a biotech company which is about to receive FDA approval for an innovative cancer drug. The stock is only 50 cents per share and once the drug is officially approved, it could easily double in value overnight. If this information were true, you would be illegally profiting from inside information but chances are the information is false. Somebody sends the email out and as people fall for the scheme, the stock price rises. Once it gets high enough, the originator of the email sells the stock for a profit causing the stock price to go back down. That person makes money and you lose money.
This scam is also easy to avoid. Never buy a stock on a tip from somebody even if you know them. If you don't know how to research a stock, you should leave it to a financial advisor. (Learn more about the FDA's impact on pharmaceuticals. For more, see A Primer On The Biotech Sector.)
Nobody falls for that anymore, right? One trait that investors have in common is that they don't learn from past mistakes and the Ponzi Scheme is the perfect example. Made famous by Bernard Madoff, the Ponzi scheme promises big returns on your investment but normally, your investment has to be big. You will get money at the beginning in order to gain your confidence, but that money is paid to you from the investment money brought in from newer clients. At some point the cycle breaks down and you find out that all of your money is gone. The best way to not fall victim to these sophisticated schemes is to not believe any claim of big profits. If somebody promises you huge returns, something probably isn't right.
TUTORIAL: Investment Scams: Dealing With Investment Fraud
The Bottom Line
Remember, those who suffered great losses at the hands of Bernard Madoff were some of the most sophisticated investors on Wall Street. They included individuals, mutual funds, hedge funds, and public retirement systems like the Missouri State Employees' Retirement System. If it can happen to them, it could happen to you. Don't let greed allow you to be a victim of a scam. (For related reading, see What Is A Pyramid Scheme?)