There is no shortage of investment scams. According to the FTC, there were 2.8 million fraud reports from consumers in 2021, and reported fraud losses increased more than 70% year over year. Some of the big deceptions of recent memory are:
- Bernie Madoff sold the promise of ten to twelve percent returns with minimal risk.
- Elizabeth Holmes sold the promise of performing extensive blood analysis from a finger prick.
- And most recently, FTX’s Sam Bankman-Fried sold the promise of making money from the mundane activity of safekeeping and transferring crypto tokens.
Many smart and experienced investors succumbed to these frauds and lost their money. The list of investment scams published by the Securities and Exchange Commission is long.
It is our human nature to seek a “deal.” Advertisers hype sales on Black Friday, even though many of the discounts are available throughout the year. We get excited when hearing of an investment offering with a high probability of above-market returns. But since returns are commensurate with risk, investing well requires avoiding the too-good-to-be-true pitches.
To help you avoid the temptation of chasing the next low-risk, high-return investment, answer three questions before investing:
- Is the return being advertised commensurate with the risks?
- If it is promoted as an exceptional opportunity, why me?
- Am I relying on others to have done the analysis?
Is the advertised return commensurate with the risks?
Be aware of promises of high rates of return. While financial markets are not perfectly efficient, in most cases an asset’s value is an accurate reflection of future returns and their uncertainty. The yield on a bond backed by the U.S. Government provides a guide: 3 to 4% is the return on a low to no-risk investment today. Anything promised above 4% has risks that need to be identified and assessed. A well-diversified stock portfolio is expected to return around 9% per year over time, with considerable variability each year. 2022 is a clear reminder that even a diversified portfolio of stocks can be down 25% in any one year. Any investment promising above 9% returns with limited downside is too good to be true. It was not possible for Bernie Madoff to continue to generate 10 to 12% returns year after year.
Why did so many people give Bernie billions? They wanted to believe him. He had been the Chairman of the NASDAQ stock exchange. He was known as a smart investor, owned an established investment firm, and dressed and lived a lifestyle consistent with success. As it became impossible to maintain the promised returns, he used the cash from new investors to pay distributions to existing clients. In other words, a Ponzi scheme.
If it is promoted as an exceptional opportunity, why me?
Since capital markets are efficient, investments tend to be priced so their expected returns reflect the risks. There is no logical reason why an investment would be offered/priced where the return is likely to be greater than the risks – so ask yourself, “why me?” Why is the asset owner, salesperson, investment manager or general partner offering this to me and not keeping the opportunity for themselves? Investments that provide returns greater than their risks are incredibly valuable. Why would someone give that away? For a broader discussion on investment temptations, read our blog Seven Ways to Fool Yourself.
Am I relying on others to have done the analysis?
A widely accepted approach in tech startups is referred to as “Fake it … until you make it.” Customers who are early adopters enjoy testing out prototypes. Elizabeth Holmes learned that not telling investors your technology is a fake and hoping that it will someday work, leads to an 11-year jail sentence. She was convicted of selling investors fake blood tests and worse, not telling customers that they were relying on test results based on unproven technology. Investors bought into the Elizabeth Holmes story for various reasons. There were luminaries on her Board of Directors (not that any of them had done due diligence on their firm’s technology) and Ms. Holmes was charismatic and had attended a couple of years at Stanford University.
The fear of missing out on the next Apple, Google, or Facebook clouds judgment. It is easy to forget that for every Apple, there are thousands of firms with premier boards led by charismatic leaders who attended premier universities that have only had mediocre results, at best. The term currently used for any private firm which has grown to a market value above a billion dollars is “unicorn.” One should pause and question why the common term for something desired by many investors is the same name as a mythical animal.
How to protect against falling victim to a scam
Some eventual scams are caused by good leaders gone astray. I would like to believe that Sam Bankman-Fried wanted to earn a living through hard work and his talents. I understand that early in his career he correctly identified trading opportunities in Bitcoin which led him to establish a clearing house and custodian for crypto tokens. Trading firms are legitimate businesses. Clearing houses and custodians are legitimate businesses. Each need to be kept entirely separate: one is based on safekeeping client assets and the other placing them at risk with the hope of earning a return. FTX’s downfall may have been mixing the two. While Bernie used new client deposits to pay existing clients, Sam used existing client assets to support a failing trading operation. The assets were not his to lend to traders.
Madoff Investments and FTX were legitimate firms at one time but in both cases, their leaders failed to have the necessary moral compass to remain responsible fiduciaries of their client’s assets.
How can an investor protect themselves from fraud by well-known individuals? Fraud is rare but does occur. The best protection is to size any investment correctly.
The higher the uncertainty, lack of history, or difficulty in assessing the fundamental value of the opportunity, the smaller the investment should be as a percentage of your wealth.
Any investment in a single sector or new technology should be no larger than what the investor can lose without impacting your family’s wealth. If you are twenty-five, skilled, and don’t mind moving back in with your parents, it may be OK to risk all your savings. At sixty-five, with more of your high-earning years passed, a single investment should be no larger than what you are comfortable losing.
You will likely be tempted by the next opportunity to earn above stock market returns. It may be presented to you by someone with an impressive resume like Bernie, by a charismatic young woman like Elizabeth, or by a disheveled MIT grad like Sam. It may be offered by a friend who honestly believes in the idea. Ask yourself the three questions above. Then, if you are truly comfortable with the answers, commit no more than you can lose. In forty years of advising wealthy families, I have never seen an opportunity that truly is too good to be true.