How to avoid investing in a scam
As financial planners, one aspect of our commitment to our clients, is to continually be on the lookout for possible scams and investment fraud. Ian De Lange from Seed Investments wrote the following article which we believe is crucial to trying to avoid investment scams.
This week South Africa was rocked with an investment scandal, that in terms of the purported sheer size of up to R15 billion, will dwarf any previous scams. While we know that despite tight regulations, there will always be scams looking for culprits, it is very important that investors assess counterparty risk before an investment is made.
In the alleged scam of Tannenbaum billions of rands were invested into a private operating company promising investors fantastic returns. It amazes how supposed smart investors apparently put in millions without a hint of due diligence.
I found this on the CFA (Chartered Financial Analyst) website, adapted slightly for local situation. There are no guarantees, but with investments it is vital that counterparty risk is reduced to as close to zero as possible.
10 tips on avoiding investment fraud – posted after the Bernie Madoff scheme came to light.
1. Understand clearly the investment strategy – “Some investment opportunities appear alluring simply because they are described in impressive, complicated terms. Investment strategies and financial products should be clear and understandable. The nature of the risks involved can vary widely and should be well understood. Even the venerable Peter Lynch advised people to invest only in what they understood – advice he abided by in his successful career. If you don’t understand it, stay away.
2. Match investment strategy to reported performance – One of the red flags in the Madoff affair is that reported performance was too consistently good. Other investment scams, popular on the internet, purport to use ultra-safe “prime bank” financial instruments from the world’s largest banks. E-mails that promise double-digit returns are incongruent with the safe investment strategies they purport to offer. Also, find out if the firm has its reported performance numbers independently audited, who audits them, and if possible whether these figures comply with Global Investment Performance Standards, a set of ethical principles for calculating and reporting investment results.
3. Watch for e-mail solicitations and Internet fraud – The internet is a low-cost way for scammers to reach millions of people. Unsolicited e-mail messages offering you investment opportunities that sound too good to be true probably are. Online bulletin boards and electronic investment newsletters are also fertile ground to disseminate false information on thinly traded stocks for a pump-and-dump scheme. Treat information from unknown sources on the internet with great suspicion.
4. Be wary of “sure things,” quick returns, and special access – Legitimate investment professionals do not promise sure bets. Legitimate get-rich-quick schemes simply do not exist. Scammers often make the implausible combination of safety and high returns seem plausible by granting you “special access” based on your relationship with a mutual acquaintance or affiliation with a specific religion or ethnic group. Also, understand clearly the terms by which you can redeem shares or exit the investment. When can it be done and what are the fees? Ponzi schemes become unsustainable when investors pull out their money.
5. Understand what, if any, regulatory oversight exists – Fraud may be less prevalent in regulated settings, like mutual funds. Hedge funds are less regulated than mutual funds and the risks must be carefully analysed.
6. Assess the operational risk and infrastructure – Any investment management operation should have a physical infrastructure for trading and administration. Ask to see them and inquire about the firm’s processes and controls. It is important that a firm have separate, independent operations for asset management, trading, and custody to provide checks and balances against fraud.
7. Ask about independent audits and who performs them. An auditor should be independent, reputable, and congruent with the size and scope of the investment operation.
8. Assess the personnel – Ultimately, the reliability of any operation is predicated on the integrity and competence of its people. So find out who makes investment decisions and who implements the investment strategy. They should be separate people with relevant experience, education, and training. Credible investment professionals speak knowledgably and comfortably about their professional standards.
9. Perform a background check. If an advisor firm or investment manager is not listed with the FSB (www.fsb.co.za), find out why. If they are, make sure their record is clear.
10. Limit your exposure – One of the surest ways to avoid the catastrophe associated with investment fraud is to limit the amount you invest. Diversification is one of the most fundamental and enduring investment principles. Investors often expose themselves to unnecessary risks by concentrating their funds in one or two securities. By limiting your exposure to five to 10 percent of your assets, the principle of diversification can protect you if an investment turns out to be fraudulent.
Although these points cannot guarantee that you will avoid investment fraud, they will increase the likelihood that you will make smart choices.
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