How To Tell If an Investment Is Too Good To Be True

There is no doubt about it: Investing involves a certain amount of uncertainty. No one can be a successful investor unless they are taking (and managing) a calculated amount of risk.

But mitigating one risk often exposes you to another. 

Plus, the market has no shortage of bad ideas and bad actors competing for your investment dollars. It’s probably an exaggeration to think of the market as shark-infested waters but that doesn’t mean the sharks don’t exist. 

But, there’s a difference between a high-risk investment and one that’s an outright scam. How can you tell the difference between one that’s worth the risk and one that’s too good to be true?  

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Warning Signs of Investment Scams

If you’re buying a publicly traded U.S. stock on a major exchange from a registered broker, the chance of that company being a scam is quite low. The company might have terrible financials and be a high-risk business but is a legitimate company trying to make money. 

Private equity, hedge funds, real estate syndicates, or other investments restricted to accredited investors require extensive due diligence, as the risk is considered too high for public sale.

Penny stocks, cryptocurrency, and investing in private businesses can be legit but are like the Wild West.

Then there are the true scams — enterprises designed to take your money without any hope of return. 

Rather than look at the details of the investment, check out what the people selling it are saying about it. Here’s what to watch out for: 

Promises of abnormally high returns 

The old adage, “If it sounds too good to be true, it is” applies. If someone is forecasting exorbitant returns on your investment, run away.

A guarantee or low/no risk pitches 

No legitimate investment broker will ever guarantee a return. Promises of high returns without risk are a con.

Not answering or allowing you to ask questions

Investment professionals want you to ask questions and understand exactly what you’re investing in. Scammers do not.

High-pressure or time-constrained tactics

Be wary of salespeople using pressure or time limits to get you to commit when you’re unsure.

The reason they don’t want you to sleep on it or take the time to read the fine print is because it’s a bad deal and they know it.

Claiming the details are too complex for you to understand

Con artists often use complexity to hide the true nature of a scam. Don’t buy into anything you don’t understand entirely.

Overselling the importance of current events

Scammers will frequently use current events, especially geopolitical events, to urge you to invest in their schemes to avoid some proposed calamity. 

Claiming insider or secret knowledge

There are thousands of brilliant, full-time financial professionals scouring the globe for any advantage they can find and the market can price in new information in minutes. The person attempting to sell you something doesn’t have some secret that's unknown to others. 

Scams almost uniformly bait their hook with huge profits, earned quickly and without effort. Don’t be fooled — the faster and larger the gain or the lower the risk or effort, the more you can be certain it’s a scam.

Good investments are simple, take years or decades to come to fruition, and are boring beyond belief. Anyone selling something different is waving a red flag.

LEARN MORE: What To Look for When Buying Stocks

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Assessing High-Risk Investments

Now, not every high-risk investment is a scam. There are plenty of businesses where the stakes are simply higher than others — which often means the rewards are higher, too.

High-volatility investments aren’t right for everyone — and not right for anyone in excess.

Luckily, we can apply some basic analysis to determine what sort of risk an investment presents and whether it suits your goals and risk tolerance.

Technical analysis 

This method analyzes stocks by focusing on price movements and trading volume.

Technical analysis is a good way to look at short-term trends but is limited in how useful it can be for predicting long-term trends.

Efficient market theory suggests that the market will discount high-risk companies over lower-risk companies as a matter of course. 

Qualitative analysis 

This method examines the company absent its share price.

It considers factors such as the company’s business model, the strength of the leadership team, any competitive advantages it may possess, and its industry’s trends.

Qualitative analysis is weak on its own but can be a valuable exercise in combination with other techniques. Leadership with prior fraud or legal entanglements, a weak business model, or a declining industry are examples of high-risk factors you can discover this way.

Quantitative analysis 

This technique works with financial data published in earnings reports of all publicly traded companies like earnings per share, revenue, and price per earnings.

Mathematical and statistical models are applied to the data in an attempt to predict future stock price movements and volatility. It can be laborious but it can reveal possible risk outcomes as probabilities.

Fundamental analysis 

This is the most intensive and complete analysis and looks at a company’s overall financial health.

Fundamental analysis assumes that a company can be fairly valued, undervalued, or overvalued, and share price may not reflect the intrinsic value of the company. The company’s balance sheet, cash flows, debt, dividends, and assets are all reviewed to determine if the company is financially sound.

• A company with a strong technical analysis but a weak fundamental analysis might correctly be considered high-risk and overvalued by the market.
• A company with a weak qualitative analysis but a strong fundamental analysis might indicate a company that is undervalued on the market, perhaps a value stock. 

No method is foolproof and a changing marketplace adds an element of error. Rest assured, if you do your homework and you can’t figure out how the company makes money, they can’t either. Avoid them.

READ MORE: Understanding Value-at-Risk and Your Loss Potential

FAQs

What should I do if I’m the victim of investment fraud?

If you’re the victim of investment fraud, FINRA offers several actions you can take to protect yourself:

• Start a fraud file with any documentation and a timeline of events, even if it’s years. 
• Learn about your rights at https://victimconnect.org/.
• Report the fraud to appropriate regulators:
  • U.S. Securities and Exchange Commission: (800) SEC-0330 or file a complaint
  • FINRA: (844) 574-3577 or file a tip 
  • NASAA: (202) 737-0900 or file a complaint
  • National Association of Insurance Commissioners: Report fraud or file a complaint to your state commissioner 
  • National Futures Association: (312) 781-1410 or file a complaint
  • U.S. Commodity Futures Trading Commission: (866) 366-2382 or file a tip or complaint
• File a report with law enforcement.
• Consider recovery options. Recovery may be difficult or impossible but options for recovery can include law enforcement, litigation, or mediation.
• Follow up after 30 days with any law enforcement or victim advocacy organizations you’ve contacted.

If you’ve been a victim, be prepared to be targeted again. Fraudsters and con artists often work in groups and when you’ve been successfully scammed you can expect additional attempts.

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