Last Updated on December 2, 2024
Overview – Avoiding Potential Investment Traps
If achieving massive investment success was easy, then everyone would be an investor by now. However, this isn’t the case.
Creating a world-class portfolio is something that takes a lot of time, effort, energy, patience, and even a bit of luck to achieve. Investors who have robust, multi-million dollar portfolios didn’t create those in a single day, or even in a few days, but rather is something that most likely took them years to achieve.
Despite this truth, there are still some people who become “investors” who seek to make as much money as they can with the least amount of effort. Conversely, an investor can become fed up with taking a slow and steady approach and instead search for the “next big thing” in an attempt to make lots of money right away.
Because of their greed and/or impatience, these people are quick to jump on what appears to be extremely lucrative investment opportunities. Upon further inspection, however, these “opportunities” are usually just investment traps waiting to be sprung.
In investing, if something sounds too good to be true, then most of the time it likely is.
Sometimes, an Investor’s Best Tool Is Their Logical Thinking
Though potential investment traps are presented in all sorts of ways and can’t always be easily spotted, there is one simple trick investors can use to uncover most of them, at least initially. This “trick” is to stop and ask if things logically add up. As obvious as this sounds, its power should not be underestimated.
Imagine one of your acquaintances telling you about a very lucrative investment opportunity, one that has an annual return of at least 40%. Sounds great, doesn’t it?
This 40% annual return sounds great until you realize that neither the S&P 500 nor the DJIA have ever exceeded a 40% annual return.
If two of the world’s major market indices, which contain some of the most prominent companies in the world, have never posted such eye-watering returns before, let alone consistently, then how could this “opportunity” achieve such an amazing feat? Clearly, things aren’t adding up.
Some financial news sites run ads, whether in the form of pop-ups or sponsored articles. There are all sorts of things being advertised, but one of the ads that commonly show up promotes “highly lucrative” or “once in a lifetime” investments.
These ads usually promise eye-watering returns in exchange for a minuscule up-front investment or claim to know about an upcoming, extremely promising investment that nobody else is privy to.
While these ads may be tempting to click on, it doesn’t take much thought for investors to realize these ads are pushing something too good to be true.
Most ads are run with one purpose in mind: to lead to a potential sale. Because of this objective, a common metric used to measure the success of an ad campaign is ROAS: Return on Ad Spend. A successful ad campaign costs the least amount of money but brings in the most sales.
So, if ads are primarily run to drive a potential sale, and if supposedly lucrative investments are being forced into your face via ads, then the ones who promote these opportunities that sound too good to be true most likely have an ulterior agenda.
If these extremely promising investments are as great as they’re made out to be, then what do these people gain by sharing this information with the public? After giving it some thought, sharing such valuable information purely for selfless reasons doesn’t make much sense, if at all.
While some opportunities that sound too good to be true require a bit more work to fully uncover, many of them can be spotted early by taking the time to stop and ask if things make logical sense or not.
Too Good to Be True vs. A Genuinely Exceptional Opportunity
While there are many things in the investing world that sound too good to be true, this doesn’t mean there are no genuinely exceptional opportunities.
Though difficult to spot, investors with a keen eye or those who have a highly refined intuition can find these hidden gems well before anyone else does. Imagine how well-off the early investors of Amazon, NVIDIA, and Microsoft are today, long before these companies entered the general investing public’s radar.
While superb investment opportunities certainly exist, sometimes they’re hard to differentiate from potential investment scams meant to lure in naive investors. There exists a very fine line between these two things.
If that’s the case, what separates a legitimate investment opportunity from a potential money sink? Adequate justification. Every worthwhile investment will always have something to back it up, whether it’s strong financial data, the potential to capitalize on upcoming social trends, or something else.
Investment opportunities that are too good to be true are quick to tout their benefits but aren’t nearly as fast when it comes to providing sufficient justification for their claims.
If the Numbers or Future Outlook Looks Too Good to Be True, It Probably Is
Earlier, we talked about a relatively simple way to detect potential investment traps, and that was to stop and ask if things logically added up. Exercising some logical thinking can be a surprisingly effective tool.
As powerful as it is, logical thinking alone is not enough to uncover all potential investment traps. Sometimes, investors will need to pair their logical thinking with some in-depth analysis to differentiate legitimate investment opportunities from ones that are too good to be true.
If further analysis is required, then what exactly will investors want to focus on? The two areas they may want to look at are financial data and prospects/outlook.
Numerical analysis is an integral component of any investor’s overall analytical work. After all, past numerical data is used to try and anticipate future performance, and in turn, try to understand investment merit.
To spot if a potential investment is too good to be true, investors will want to keep an eye on irregularities in the data and ascertain if these irregularities have some kind of reasonable explanation.
For example, imagine a certain tech company has recently been garnering attention among investors due to its unbelievable capital appreciation and generous dividend. While at a glance this looks to be a no-brainer investment to pursue, after looking at its financial data you notice that it has been posting losses for the past several years, its debt is skyrocketing, and revenue is stagnant.
With this information in mind, this supposedly stellar investment opportunity could instead be a disaster waiting to unfold. Many tech companies during the infamous Dot-Com Bubble shared the same characteristics: rapid increase in share price, yet horrendous underlying financial performance.
The numbers never lie, and any form of financial dishonesty, whether deliberate or not, is usually a precursor of a potential investment trap.
Some investment opportunities that are too good to be true attempt to market themselves by painting a very optimistic picture of the future. Whether it’s exclaiming “This trend is the next big thing” or “This new technology will change the world”, some investment traps rely on hype and naivete to lure people in.
By attempting to oversell certain trends, these “opportunities” hope to capitalize on people’s optimism, even if there’s nothing substantial to back it up.
As we’ve talked about in a previous article regarding social trends and investing, there are all sorts of trends that exist at any given time, but not all of them go on to be revolutionary, and even fewer lead to exceptional investment opportunities.
An investment “opportunity” that tries to sell itself as the “next big thing” with very little substance to back the claim up could potentially be a trap waiting to be sprung.
If It Sounds Too Good to Be True, Then a Bit of Skepticism May Help
Up to this point, we’ve discussed a few ways to uncover potential investment traps which were: asking if things logically added up, checking to see if the financial data is sound, and ascertaining if the future outlook is justifiable.
While these methods can certainly be effective, they are all connected by the same, underlying philosophy, and that is having a healthy sense of skepticism.
Maintaining a healthy sense of investment skepticism doesn’t mean being paranoid about everything. Rather, it simply means not taking everything at face value and instead taking the time to verify the legitimacy of what’s being presented.
By learning to put their guard up when presented with something that sounds too good to be true, investors can potentially save themselves the trouble of falling for an investment trap.
A case study of when a healthy sense of investment skepticism would’ve been highly effective is that of Theranos.
Theranos, founded by Stanford dropout Elizabeth Holmes, is widely regarded as one of the biggest corporate frauds in history, drawing parallels to the infamous energy company Enron. Full details of the rise and fall of Theranos can be found in this book.
Put simply, Theranos was built on the promise of producing technology that would make blood tests significantly faster and easier. This promise resulted in an abundance of investment and a boon to Holmes’ fortune.
However, the technology that Theranos promised didn’t work, resulting in the company’s billion-dollar valuation plummeting to zero and Holmes facing several criminal charges.
Investors of Theranos could’ve avoided having their capital wiped out had they maintained a sense of skepticism by ascertaining if the technology worked as promised, and checking to see if the financial data was as promising as Holmes made it out to be.
Wrapping Up
There’s no shortage of malicious actors who prey on investors who either want to make a quick buck or are fed up with all the work involved in taking a “traditional” approach.
To capitalize on this greed and frustration, these actors peddle certain investment “opportunities” that sound way too good to be true. However, as the saying goes, if it sounds too good to be true, then it probably is – investing isn’t exempt from this.
Fortunately, there are ways for investors to detect and hopefully avoid these potential traps. Asking if things logically add up, scrutinizing financial data, and understanding the potential of future outlooks are all effective tools.
Ultimately, discerning legitimate investment opportunities from ones that aren’t comes down to having a sense of skepticism, which involves digging deeper instead of taking everything at face value.
