Avoiding Scams

I think I live in the scam capital of the world.  It seems not a month goes by that some local pyramid scheme isn’t uncovered.  There are even billboards on the freeway teaching residents how to avoid getting scammed.

One of the secrets of a successful investor is to avoid making big mistakes.   I’ve written before that physicians have already won the financial “game.”  With a six-figure salary, all you have to do is save 20% of your income each year and invest it in a reasonable, low-cost way.  Since you’ve already won the game, concentrate on not throwing it away!  One of the ways that physicians sabotage their own retirement plan is to get involved in scams.  Usually this is because they fall for a too good to be true offer.  Here are a few examples:

The Medical Advisory Board Scam

In this scam, physicians are contacted to serve on the medical advisory board for a phony company making a phony medical product.  The doctor is offered money shares of stock as compensation and even offered all-expense paid company trips for meetings at resorts.  The scammers may even maintain a plush office to fool those who actually try to do some due diligence.  After a while, the company executives will invariably offer to allow you to buy more stock, promising rich returns when it goes public or when the device goes on the market.  Once they’ve bilked enough docs out of money, the company folds and disappears.  A good example of this scam was Medical Research Industries.  They made patches that were supposed to help people slim down, get more sleep, and perform better in bed.  2500 investors, mostly docs, lost $52 million.  They eventually ended up in trouble with the FDA and SEC.  Judgments were obtained, but little was left for the investors to collect.

Multi-Level Marketing

Most of us are familiar with multi-level marketing companies such as Amway or Mary Kay.  These legitimate companies have their own issues caused by their focus on recruiting a down-line rather than actually building a business and selling good products.  But many multi-level marketing companies are simply a scam or even a pyramid scheme.  After a certain amount is invested, (perhaps even providing great returns to the person who got you into the scheme) the company simply disappears.

Pump and Dump

You’ve seen the emails for these.  It’s almost always a micro-cap stock “about to go big”.  It is usually sold “over the counter” or “on the pink sheets”.  It starts rapidly climbing in value as it is “pumped” by the operators.  It wouldn’t be unusual for the stock price to go from $0.50 to $5.00 a share at which point the investors start piling in.  Just as the stock price peaks, the operators dump their shares and the price rapidly crashes back to where it began, or even lower.  It can work in reverse in a “short and distort” scheme where instead of talking up a stock, they talk it down, then short it.  The reason this scam endures is that there is little information available about these tiny companies.  Unlike Bank of America or Exxon-Mobil, they don’t have dozens of analysts following it and combing through their financial records.  Large stocks occasionally have pricing irregularities, but these stocks that are too tiny to be on a stock exchange can be so inefficient that it is easy to be preyed upon by those with superior knowledge.  Efficient market it isn’t!  To boot, these stocks have a tiny float, meaning there aren’t that many shares out there and just a few being bought and sold can severely distort the price.  Sometimes these pump and dump schemes are perpetuated on internet bulletin boards or even legitimate-looking investment newsletters.

Off-Shore Banking

Many scammers take advantage of physicians’ hypersensitivity to paying taxes.  They encourage movement of your hard-earned money to international financial centers, such as in the Caribbean.  Low taxes and pro-business laws can create some unique opportunities there.  There are some legitimate foreign investments, but there are just as many scams and con-men out there.  Once they have your money out of the US, it becomes much more difficult to get it back.  Their local politicians and attorneys are often in on the scheme and will help keep the scam quiet until it is too late.  These financial centers don’t want word of scams getting out, lest they lose a lot of their more legitimate business as well.

The Rules

Most of these scams are relatively easy to avoid by remembering a few simple rules:

1) If it seems too good to be true, it probably is.  Almost without fail, scams promise a ridiculously high rate of return.  If the historical rate of return of the volatile and risky stock market is 8-10%, what kind of risk should you expect from an investment promising 50% returns?

2) Skeptical Uncle Test.  We all have a relative that is a real skeptic.  Could you convince him to invest with you?  Would you be embarrassed to even bring it up and discuss it with him?  There’s probably a reason.

3) Wall Street Journal Test.  Many investors abide by the rule that they never invest in anything that they cannot look up the price of every day in the Wall Street Journal.  While that obviously excludes many legitimate investments, it does nearly completely prevent you from being scammed, aside from the occasional WorldCom or Enron debacle.

4) Diversify.  Avoiding single company and single asset class risk is a good way to avoid losing too much.  Any investment that requires you to invest 1/4, 1/2 or even all your assets is a good way to lose a large chunk of your savings.  Losing 1% of your assets just doesn’t hurt that much.  Get rich slowly and surely is a much better plan than trying to hit it big with one investment.

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5) Familiarity test.  Does this sound similar to a Nigerian Scam, a pyramid scheme, or a pump and dump scheme?  It’s amazing how most scams are just variations on a few classical scam themes.

6) Don’t buy things from people who cold call you, people who come knocking on your door, or people you meet at church.  Good investments are bought, not sold.

7) Don’t believe everything you read on the internet or in a newsletter.

8) Ask for regular audited returns.

9) Actually check references.

10) Don’t give out sensitive information or pay upfront fees.  You’d be surprised how many people voluntarily gave out their social security number or their bank account information or paid thousands of dollars in fees up front with little more than verbal reassurance.

11) Don’t be needy, greedy, or naive.  Live frugally so you don’t end up in a situation where you need to make a quick buck or need the ridiculously high promised returns to meet your goals.  Education helps too.  If you’ve heard of a scam, or something similar, you are much less likely to fall for it.

12) Take your time.  It is extremely rare that you need to rush into any investment.  It is almost always to your advantage to take your time making a decision.