How to Spot a Financial Scam

By Posted on May 18, 2017

121 Financial

How to Spot a Financial Scam

Scams are everywhere. Most people would be shocked to learn how something that seems routine and completely safe can be turned into a financial disaster for them and their family. They would be further shocked to learn the meager recourse available to repair the damage. Too often, by the time a scam is discovered, the perpetrator is long gone, along with your money.

The key to avoiding a financial scam is recognizing it before it happens. Here are a few things to look out for.

The Ponzi Scheme

Return and risk are proportional. When someone comes along promising high returns and low risks, there must be something extraordinary to make up the difference. If there isn’t something outside the investment structure providing the returns, you are very likely looking at a Ponzi scheme. The key feature of a Ponzi scheme is the lack of any independent source of revenue. Rather, capital obtained from new investors is used to pay previous investors and make it look as if the venture is making money.

Pyramid Scheme

A pyramid scheme is somewhat similar to a Ponzi scheme, except that the pyramid provides many “founders” with revenue from new recruits, rather than having all revenue funneled through a single person or entity. Each new investor is essentially responsible for bringing another layer of “investors” to pay himself. There is often a product of some kind, but sales are only tangentially important to a pyramid. The real revenue comes from the buy-in from new recruits, who are often required to capitalize their own portion of the market with non-refundable purchases of inventory or territory rights.

An important clue that a business is actually a pyramid scheme is the high buy-in compared to the assets you’re being asked to purchase. Sales projects are supposed to get their money from buyers, not sellers.

Proxy Investments

If you are in the U.S., any time a person offers to make an investment on your behalf, the fastest way to verify the legitimacy of the deal is to ask if they are registered with the Financial Industry Regulatory Authority (FINRA). If not, they may already be in violation of federal law. Performing any activity that qualifies under the Securities and Exchange Act as fiduciary is regulated by the Securities and Exchange Commission and requires considerable testing, certification and qualification.

These criteria apply regardless of the type of investment or where it is based. If your “investment advisor” can’t produce the proper certification, their deal, no matter how attractive, is best avoided.

General Rules

The proportional relationship between risk and reward can’t be emphasized enough. Legitimate high risk investments like small cap stocks, for example, are those which have potential for the greatest return but also have the highest risk that investors will lose their capital. On the other hand, investments that are very safe have low returns. Finding a high return/low risk investment is like finding a unicorn.

Think about it. If an investment is totally safe, why would the principals be willing to pay a lot for your capital? They could just fund their business activities out of profits. If you owned a producing gold mine, would you need investors? It’s only the gold mines that aren’t proven yet that have to promise big returns for the capital that will enable them to keep digging, should they ever find the gold.

When you have a question, please reach out to us!

5/18/2017