Five tips to avoiding investment fraud

1. Avoid cold callers

Fraudulent sales organisations or ‘boiler rooms' operate out of other countries with lax financial regulation. Once a boiler room sales force has found a prospective victim, it can be very persuasive. Every year hundreds of investors part with substantial sums for shares that turn out to be worthless.

Boiler room fraud is, however, easily avoided. The biggest warning sign is that these salesmen have cold-called you (a fact that they will try to make you forget). No legitimate professional will call you offering an investment product unless you have invited them to do so.

If you receive an unsolicited call, just put the phone down.

What's a boiler room scam?

2. Be wary of hedge funds

Unlike most traditional funds, hedge funds are almost completely free of restrictions on the investments they make, and are thus able to take on much higher risks, with potential for higher returns. The FSA believes there is an increased likelihood of fraud in the hedge fund industry because of its light regulation, weaker controls and high rewards for fund managers.

To date, the biggest hedge fund fraud was committed by the Bayou Group, which collapsed in 2006 owing its investors some $300 million (£188 million). Approach such funds with caution and undertake a thorough due diligence investigation (independently verifying all the key elements of an investment on offer and considering all the possible risk) before deciding to invest.

3. Are the accounts transparent?

Back at the start of the last decade, Wall Street analysts went crazy for US energy, commodities and services company Enron. However, it was plain long before its collapse in 2001 that Enron's accounts were not transparent, and its sexy creative accounting methods should have raised eyebrows among sharp-eyed investors.

The obvious warning sign with Enron and its accounts was the ridiculously rapid growth in the company's sales – to more than $100 billion in 2000, up from some $40 billion in 1999, $32 billion in 1998, and $20 billion in 1997 – at the same time as its percentage of profit was declining. According to some estimates, if Enron had not used certain creative accounting methods, its 2000 sales figures would have been just $6.3 billion.

Ultimately, it was not possible for an out- sider to penetrate the accounts provided – but that in itself should be a warning sign. The moral? If you can't understand the accounts, don't invest. And don't rely on the analysts to do the work for you.

4. Don't be ‘pumped and dumped'

Naive investors often hope to make money fast by investing in a series of single, high-risk companies, often listed on obscure stockmarkets. If you are an investor who can't resist taking a punt on some hot new company, be warned, you could become the victim of a ‘pump and dump' scam. This is any type of fraudulent operation that involves persuading investors that the shares of a certain company, often a small one in an obscure sector or market, are rising, in order to sell shares the fraudster bought cheaply.

One of the largest scams so far centred on Bre-X Minerals, a Canadian mining company that collapsed in 1997 after its claim that it had discovered an enormous gold deposit, in Busang, Indonesia, proved false. If you encounter a situation like the Bre-X ‘find', recognise the possibility, how- ever remote, of fraud.

It is foolhardy and amateurish to bet all your money on one outcome. It is far better to spread risk. It won't prevent a loss on a given investment, but it will reduce the damage a loss causes you and allow you to live on and fight another day.

How much of an investment risk-taker are you?

5. Know what you're doing

Perhaps the cardinal sin in investing is ignorance. The fact that you have money does not make you a financial expert. If you want to minimise the risk of fraud, it's essential to educate yourself about investment and investment fraud, and continue to do this for your entire investing life. It is equally important to be careful about where you get your investment education from. Be discriminating.

This feature was written for our sister publication Money Observer

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