7 Common Investment Scams

The North American Securities Administrators Association (NASAA) recently published its list of common investment scams. Here are seven of the most frequent that could waste your time, money and energy.


1. Affinity Fraud: Con artists foist questionable investments on members of close-knit political, ethnic or religious groups.

2. High-Interest Promissory Notes: Offered by companies that advertise terrific returns. The higher the number, the more likely the scam.

3. Sale and Leaseback Contracts: Targets are offered equipment like ATM machines, Internet booths and payphones, which often don't exist.

4. Oil and Gas Investment Fraud: These scams prey on oil fears by touting new drilling discoveries.

5. Personal Information Scams: These happen when someone pries out financial data and then uses the information to open a credit account.

6. Self-Directed Pension Plans: Targets withdraw money from an existing pension plan, which is then funneled into a worthless venture.

7. Recovery Rooms: If you've been scammed once, so-called "reloaders" come back to you from "recovery rooms," promising to recover that sum.


If you think you are the victim of one of these scams, or are aware of one, contact the U.S. Securities and Exchange Commission (SEC) at www.sec.gov or 800-732-0330.

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Understanding Beta

Beta is a term commonly used by financial consultants and economists, but what is it exactly?

Beta is a measure of the volatility of an investment in comparison to an index or benchmark. A high beta (greater than one) indicates more volatility than its index or benchmark, and a low beta (less than one) implies less volatility.

For example, a stock with a beta of 2.5 in relation to the Standard & Poor's 500 suggests that when the index rises 10%, the stock appreciates by 25%. Conversely, if the S&P falls by 10%, the stock would lose a quarter of its value.

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About Portfolio Risk

A portfolio's risk consists of "systematic," or "market" risk, and "non-systematic," or "stock-specific" risk. A 10-stock portfolio would have the same systematic risk as a 100-stock portfolio, but the smaller portfolio has more stock-specific risk because it's less diversified.

Unfortunately, the only risk category that gets rewarded with higher expected returns is systematic risk (which is identical for both portfolios). The market doesn't reward a failure to diversify with higher expected returns.

In a situation where the same stock is being held in a 10-stock or a 100-stock portfolio, if the stock doubles in price, it's effect on actual performance (after-the-fact returns, not expected returns) will depend on the stock's weight in each portfolio -- if it's 10% of the 10-stock portfolio and 1% of the 100-stock portfolio, the smaller portfolio would outperform the larger. But if the stock was 10% of both portfolios, the performance effect is identical.

But the key point is that actual (after the fact) returns may be higher or lower than expected. In the long run, the 10-stock portfolio is more risky, but it's not guaranteed a higher return as a result -- it's just as possible that the single stock could fall by half.

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ADRs For The Retail Investor

Ease of use - ADRs are quoted in U.S. dollars, trade just like U.S. equities, and settle through a U.S. clearinghouse just like a U.S. security.

No-Hassle Dividends - ADR investors receive their dividend checks promptly and in U.S. dollars.

Access - ADRs offer U.S. investors easy, low-cost access to some of the world's best equity investment opportunities.

Do-It-Yourself International Diversification - Unlike mutual funds and ETFs, ADRs give U.S. investors who want global diversification the opportunity to select exactly the foreign companies they like.

English Spoken Here - Corporate communications, including shareholder reports, financial statements, and corporate actions are translated into English for ADR holders. Plus, current trading data is readily available.

Transparency - Issuers of exchange-traded ADRs are required to maintain the same financial reporting standards as U.S. companies with comparable exchange listings.

Lower transaction costs - Brokerage commissions on ADRs are similar to commissions on other U.S. equities. And international investing through ADRs avoids foreign brokerage and currency exchange commissions.

Lower custody fees - Foreign custody fees range from 10 basis points per year on the value of the investment in developed markets to more than 35 basis points per year in emerging markets. By contrast, custody fees on ADRs - as with U.S. equities - are often no more than $35 and are not based on the value of the securities.

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Investing In Foreign Stocks

It is possible for any U.S. investor to invest in foreign companies without the need of an offshore brokerage account. How is this done? By the use of ADRs - American Depository Receipts.

The first ADR was created in 1927 by JPMorgan, as a vehicle for U.S. institutional investors to indirectly own shares of Selfridges, the British retail chain, despite U.K. restrictions prohibiting the actual securities from leaving the country.

Today, some 1,812 foreign companies from more than 80 countries have depository receipt programs - and there are currently 462 ADRs listed on national stock exchanges, mostly on the NYSE, which has 328 listed ADRs. Another 940 ADRs trade in the over-the-counter (OTC) market.

Despite their foreign accent, many ADRs have long been household names familiar to U.S. investors, companies like Cadbury Schweppes, Honda, Sony, and Novartis.

ADRs certify that the underlying shares of a non-U.S. company have been deposited with the depositary's custodian in the company's home country.

ADRs most often represent an equivalent number of shares - but occasionally the ratio of ADRs to underlying shares may differ. So, for example, one ADR might represent a fraction of the underlying share while another might represent 2 or 3 shares of the issuing company.

Although ADRs are, in fact, issued by a depository institution, the foreign companies whose shares they represent and which, in most cases 'sponsor' their issuance, are often referred to as the "issuers."

Importantly, ADRs are U.S. securities and, as such, they are regulated by the Securities and Exchange Commission (SEC). They are denominated in U.S. dollars, and like other U.S. securities they trade in dollars. ADR owners also receive dividends in dollars and corporate communications are in English.

ADRs are bought, and sold, and clear just like any U.S. equity - and transactions costs are also similar. As U.S. securities, they can be held by U.S. institutional investors, such as pension plans, which otherwise may be prohibited by their own charters from owning non-U.S. securities.

Depository institutions, such as JPMorgan, provide a variety of services that are important to the retail and institutional investors who buy, hold, and sell ADRs. And one of their most important functions is to create and cancel ADRs in behalf of investors so that the supply and demand for ADRs in the U.S. market remains in equilibrium with the supply and demand for the underlying shares in the home market. This assures that prices in both markets are always comparable, allowing for transactions costs at the current exchange rate.

So, for example, if the price of an ADR on the New York Stock Exchange rises above the price of the underlying security in the home country market, it is these "behind-the-scenes" activities by depository institutions that makes U.S. investment in foreign equities through the mechanism of American Depository receipts virtually indistinguishable from investment in the shares of any American company.

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The Magic Formula Approach to Stockpicking

This is an interesting investment approach that was originated by Joel Greenblatt, author of, The Little Book That Beats The Market.

The philosophy behind this approach is for the person to invest in above-average companies (those with high return on capital) when they can be purchased at below-average prices (high earnings yield). Companies with a high return on capital are desirable because they are profitable, and can have the ability to grow with a high return on investment and expand earnings at a high level of growth.

Short-term market distortions often allow investors to buy a good company when its earnings yield is high (earnings divided by price) and sell as the market correctly prices the company over the long term.

The Magic Formula excludes micro-caps, foreign companies, utilities, and financial stocks, and uses the 3,500 largest companies available for trading in the U.S..

You can find out more about this investment approach by clicking on "Magic Formula Investing" in our "Links" section.

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Understanding The Time Value of Money

Let's suppose you go shopping for a piece of very sophisticated exercise equipment. You find the one you like, and the dealer offers you this choice:

Which of these two options would you choose?


* Price today of $4,000

* 36 year full parts and labor warranty

* All your money back - $4,000 - at the end of the warranty period.

OR:

* Price today of $3,000

* 36 year full parts and labor warranty.

* $0 rebate at the end of the warranty period.


Would you rather pay less today and get no rebate, or let the dealer use your money for 36 years and get 100% of your money back?


Answer:


The exercise equipment dealer can invest the $1,000 difference today and let the compounding of interest work for him/her instead of for you.

Suppose instead that you have that extra $1,000 and the self-discipline to invest it in something that earns a 12% yield. $1,000 invested at 12% will grow to $64,000 in 36 years.

If instead, you gave that $1,000 to the exercise equipment dealer, in 36 years, he could rebate your full purchase price of $4,000 and keep a (hypothetical) profit of $60,000 for himself.

The REAL Question any investor should be asking him(her)self is this:

With the same $1,000 and the same 36 years, why would you want someone else to have your $60,000?

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About Investing Globally

Traditionally, the primary way to buy shares of overseas companies was either through mutual funds, or else by buying shares of foreign companies that are listed on stock exchanges in the United States. Now, however, several brokerage firms are making it easier to invest abroad: Charles Schwab has cut prices on international stock purchases by U.S. clients; and E-Trade plans to expand its international service to let U.S. investors trade foreign stocks in local currencies. And Fidelity's brokerage section now enables its clients to buy individual shares in 36 foreign markets.

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Foreign Interest

We read in Business Week that up to this point in the year, investments in foreign stock mutual funds have outpaced U.S. funds by almost $4 to $1. Those investors who send most of their money abroad are obviously betting on one of two scenarios eventuating: One, that they will be nimble enough to reverse course in the event the dollar strengthens; and two, they believe that the dollar is in a permanent long-term decline because of America's seemingly intractable budget and current-account deficits.

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How The Yield Curve and The Future Are Related

While there is no definite method for predicting the economic future, the yield curve does provide us with fact-based signs that can serve as a guide when making investment choices. And here are some questions and answers that will help you in applying a study of the yield curve to your own investment strategy.

What is the yield curve?

The yield curve is a graphical representation of the interest rate movements of U.S. Treasury bonds of various maturities. While the rates of bonds of different maturities move independently - even in opposite directions - the curve itself depicts an overall pattern of rate movement in a single graphic, and the type of curve can be an indicator of either a future expansion of, or recession in, the U.S. economy.


What types of curves are there?

There are typically three types of curves:

1. A "normal" curve - which occurs when long-term rates are higher than short-term rates. This generally indicates that the Fed will be friendly toward the markets, with a steeper curve indicating economic expansion.

2. A "flat" curve - which occurs when all maturities have the same yields. This can be a predictor of an economic transition, signaling a move either into or out of a recession.

3. An "inverted" curve - which occurs when short-term rates move higher than long-term rates. This often means the Fed is intentionally slowing the economy, and that investors feel that interest rates will eventually move lower. A steeper inversion often accurately indicates a greater risk of recession. In fact, eight of the nine most recent bear markets occurred along with or shortly after a yield-curve inversion.


How can you use the yield curve?

If you invest in bonds, the yield curve can help you determine which maturities may be right for you. If you hold credit card debt or an adjustable-rate mortgage, the curve can help you determine if you should consider changes in how you manage that debt. And because of its depiction of the potential expansion or recession of the U.S. economy and financial markets, the yield curve can also help you decide how much to weight your portfolio toward U.S. equities.

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