Getting a good sense of the risk in the investment is important but not without some effort. Solid research is the first step before putting your money in an investment, even if it is hot tip. Having an interest in what the company does can help to create excitement in your investment. Another important element to consider, in your decision making, is the trustworthiness of the person recommending the investment to you.
The SEC’s Office of Investor Education and Advocacy provides a variety of services and tools to address problems you may face as an investor. One of these tools are the Investor Alerts. They are focused on recent investment frauds and scams. Another tool is the Investor Bulletins which are focused on topical issues including recent Commission actions. They are free to the public.
It’s not possible to invest in the securities of a company without some risk. After doing your due diligence research, here are some of the telltale signs, you can find in the Investor Alerts, letting you know the investment might just be too good to be true. Think of any one of the them as a red flag on the playing field.
1. Shady broker tactics
Start research with the understanding that the stock broker’s job is to sell. When the broker tells you the investment is ‘the next best thing’, it is appropriate to be suspicious and unconvinced. Ask the broker, ‘why do you think is it the next best thing’. You can also ask the broker to send you information which supports the broker’s belief ‘it is the next best thing’. Turn on the caution light if the broker’s answer is the stock is ‘too hot’ to wait, or the ‘deal will be gone’, or there is a ‘limited time’ for you to get in on the deal.
In my experience, there is always another ‘hot deal’ and time to do your research. If there is not enough time for you to do your research, then it probably wise to let the deal go.
2. Borrowing money to make the investment
For most people, borrowing money to purchase stock for an investment, is not a sound strategy. If you cannot afford to lose the money you invested in a company’s stock, then you should not make the investment. Just as the price of a stock can go up it can also go down. There is no legitimate way to know, for certain, if the price of stock will go up. Just because it did go up does not mean it will continue to go up. Borrowing money to make an investment in something which may very well lose money is not a strategy for success.
Legitimate stockbrokers and financial advisers should know their customer’s risk tolerance. Borrowing money to fund an investment is only appropriate for all but a few highly sophisticated and qualified investors. Everyone else should run fast when a broker suggests borrowing money or using your life savings.
3. You can’t sell the shares
Selling the shares is the way to turn your investment back into cash. If there is no way to sell the shares or if it is very difficult to sell the shares, then you might want to reconsider the opportunity. There are some legitimate reasons for it being difficult to sell shares like there shares are not publicly traded or the shares have an SEC 144 legend printed on the face of the certificate prohibiting them from being sold. The shares may be unregistered. While these are legitimate reasons, they also dramatically increase the risk for your investment. If you cannot afford to easily lose the money or you are not an experienced investor, the best advice is to stay away.
Additionally, not being able to easily sell your shares is generally an indication the investment is problematic, very risky and maybe be fraudulent.
4. The investment is difficult to understand
If you have any difficulty understanding the investment or the terms of the investment, stay away. A good investment is not hard to understand. The investment may involve a new technology, process, strategy or method. It may employ new terminology. However, if it cannot be easily explained to you in a way that makes sense and you can fully understand, stay away from the investor and the investment. If they are telling you that you are too old, young, new, financially inexperienced or not able to understand the investment for any reason, then do not make the investment. Stay away and wait for an investment you can understand.
5. The investment has an unbelievably high return
Legitimate investments have risks. If the investment has no risk or very little risk and it also has a high return, it is mostly likely, too good to be true. If the investment also has a rapid return, be very wary. If the investment is also better than all other companies in the same industry, get very skeptical. If you hear the words ‘guaranteed return’ or anything remotely similar, run fast.
As a young Wall Street stockbroker, my older, wiser, more experienced friend, Aaron Freudlich, once told me, ‘Kid, if it’s that good why is that guy wasting his time telling you about it. Why isn’t that guy so rich, he is doing nothing but getting a tan on Miami Beach! Kid, there’s something wrong with the deal. Walk away, now and find another one.”
If an investment sounds too good to be true, it’s probably because it isn’t