Steve Coker, CFP
How To Tell If Something Is a Scam
As returns on publicly traded investments like stocks and bonds struggle, investors are turning to “special” private deals that claim to offer higher returns that are not available anywhere else. These types of deals usually include investment in things like real estate, private equity, and start-up firms, which are known in the financial world as alternative investments because they are alternatives to traditional stocks and bonds that are publicly traded on a regulated exchange. Of course, just because an investment is private does not mean that it is safer than stocks and bonds. In fact, these types of investments are often riskier since they have less regulation. Similarly, these investments may or may not have higher returns than stocks and bonds. Here are red flags and key principles when considering an investment.
1.) Always Approach a “Special” Deal with Skepticism
Whenever a salesperson approaches me with a “great deal that you can’t get anywhere else” my go to question is always – if the deal is so great, why aren’t you keeping it to yourself? If someone approached me and said this is the best car I have ever had and it works perfectly, would you like to buy it, I would wonder why they are selling it.
2.) Seek to Understand What the Seller Stand to Gain
If someone is selling an investment, it is because they stand to gain something. The question that follows then is – how? Do they gain when I lose? If the investment requires you to pay a fee regardless of what happens, then the incentive for the investment to do well is low, however, if the manager of the investment is compensated when you make money, he has a great incentive to make sure the investment is profitable.
3.) Data, Data, Data,
Finance is a quantitative industry and while too much data can be overwhelming, no data at all should also cause you to pause. A good manager should be able to produce solid examples of historical returns. While historical returns do not predict the future, they do show that management has a proven business methodology. Similarly, a business plan
4.) How do you get out?
Typically, private investments cannot be easily sold, which is a defining characteristic of a private investment. This does not mean the investment is a scam, but it does increase the risk of the investment if the investment does not perform, the economy changes, or your situation changes. Unfortunately, private investments often over promise on investor’s ability to get out of the investment, promising share redemptions that only work if everything is going well.
5.) Remember diversification Of course, one of the most important ways to limit losses on an individual investment is to limit the dollar exposure to the investment. Diversification is important and is even more critical when investing in alternatives since they are often highly concentrated investments, such as a single apartment building. If the investment fails, then investors could risk significant loss.
Alternative investments are not all bad – some can be extremely attractive. However, it pays to carefully consider these types of investments before diving in.