The Motley Fool

3 Signs of an Investment Scam

It’s not too far-fetched to state that the world is full of people who are trying to swindle others of their money. Almost every week, we come across media articles on ignorant or greedy people getting cheated out of their hard-earned savings, while the perpetrators get away scot-free. As investors, how should we protect ourselves from such scam artists?

One method I personally use is to look out for “red flags” that immediately catch my attention. Here are three of my top signs that an investment idea or scheme may actually be a fraud in disguise.

1. Tough to understand how the business makes money

The most important thing about investing in a business or scheme is to understand how it makes money. Many fraudulent schemes do not bother explaining in detail how money is made and how the purported returns are generated. There is just some vague assurance provided as to the strength of the business model.

If investors find that they do not understand how money is made, it is probably because the scam operator does not want them to fully understand it. By being vague and evasive, the swindler hopes not to get too many detailed questions – as they’re unable to answer them satisfactorily!

2. Returns promised are too good to be true

Another obvious red flag would be the abnormally high returns promised by the investment scheme. I have heard of scams which promised returns of 2% per month, which works out to 24% per annum! While it is entirely possible that there are investments out there that generate such high returns, chances are that it would only be available to a small select group of clients, usually either high-net-worth individuals or corporations.

A scam usually touts high returns in order to entice people to sign up with them, playing on their greed instinct. Astute investors, therefore, have to temper their greed instinct with logic and question how such high returns are possible. If the investment manager is unable to provide a fair explanation, the investor should walk away.

3. Money is locked up in unfamiliar asset classes

Watch out for schemes that promise sky-high returns in arcane or esoteric asset classes. Such asset classes may include fine wine, gold buy-back schemes or land banking, and may only be well understood by people with specialised knowledge. This is not to say that investment schemes involving unfamiliar asset classes are definitely scams but we should be especially vigilant if we encounter such examples.

Certain asset classes may suffer from illiquidity (i.e. difficulty in buying and selling the asset), lack of a proper market system (i.e. no organised exchange for buyers and sellers, resulting in transactions having to go through OTC or over-the-counter markets) and high fees (brokers may claim that they need to charge high fees in order to execute transactions, and there is no transparency in terms of the magnitude of fees charged).

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.