With the collapse of the FTX crypto exchange, many people are asking, “How could we have seen this coming?” Others say they’d had their doubts all along. So, what strategies could people have used to discover the flaws in the exchange? By learning to spot red flags in investment opportunities, you can avoid losses and keep your nest egg invested in solid products.
Keep in mind that nothing is certain. Even top-rated investments sometimes crater, while unlikely businesses end up succeeding. But paying attention to a few basic warning signs will help you skip obvious scams.
Red Flag #1: Implausible Promises
Alameda Research, a crypto trading firm founded by FTX owner Sam Bankman-Fried, promised investors 15% returns with no risk. Since real risk-free investments, like bonds, have much lower returns, it sounded too good to be true. And, of course, it was. Nobody can offer returns like that without taking on some risk, because the higher returns always come from more volatile investments.
When you see phrases like “guaranteed returns,” “no risk,” and so on, check to see if this is something that is really guaranteed in any way. While fixed-income products do exist—government bonds, certificates of deposit, and so on—they don’t produce very high returns compared to riskier products. When in doubt, keep digging. A financial professional can probably tell you where the catch is hiding.
Red Flag #2: Regulation Dodging
FTX was located offshore, in the Bahamas, to avoid US regulations. Companies may bill this as “avoiding red tape,” saving you money and expanding the possibilities, but it can also be a red flag. Financial regulations exist to protect consumers. When you invest in companies outside of the American regulatory sphere, you may not have the same protections you would when you invest domestically.
Another way companies avoid regulations is by producing new products for which a regulatory system has not yet been developed. Take NFT real estate. By selling houses on the blockchain, through a shell company, Roofstock claims to be able to bypass the usual red tape involved in buying a house. No more looking up the title, getting title insurance, and so on—you can buy a house with one click! The problem, though, is that you miss out on all the protection the usual steps got you. Worse, you don’t actually get the deed of the house. For all new products, there are a few investors taking a much bigger risk by being the first. Until we see how it pans out for them, it’s hard to know whether or not it’s a safe choice.
It is possible for accredited investors to invest in products not registered with the SEC. However, the fact that you can legally do so doesn’t make them good choices. The qualified investor requirement exists to make sure you either know what you’re doing or can take the loss if it ends up going badly. But you’d probably rather not take the loss. If you’re wealthy enough to get involved with unregistered investments, you can afford expert guidance on your way. That can prevent missteps and costly losses.
Red Flag #3: Over-Leverage
A key weakness identified in FTX’s downfall was its close ties to other businesses, especially Alameda Research. By having both businesses under the same leadership and using funding from each to prop up the other, Bankman-Fried was able to make them appear more sound than they really were.
What’s the takeaway here for investors? Look for companies that do business with a variety of others rather than staying in a tight web of close allies. And remember that a solid company has cash reserves and is not simply leveraging debt. Over-leveraging is when a company borrows excessively, eventually becoming unable to meet its obligations. Taking on debt for capital expenditures and expansions can be a sound business decision. But take it too far, and soon interest payments eat up all your profits.
Always Do Due Diligence
When considering a new investment opportunity, it’s always worth your time to do research. Admittedly, it’s not possible to detect every scam ahead of time. Regulatory laws can’t protect you from scammers who lie and break the law. However, weak investments sometimes display red flags that you can spot and avoid. Remember to always loop your financial advisor in on any investments you’re considering. As an industry expert, they’ll be able to point out flaws in the business plan or the company’s promises. If you don’t have an advisor, contact us today to be connected with the right professional for your needs.