Every time I read about a Ponzi scheme, the scenario is similar.  Investors are offered a high or steady rate of return, with little or no risk.  The promoter of the scheme often spends the invested proceeds on a lavish life style, and generates false statements showing great results, until something triggers discovery of the fraud.

Of course, not all investments featuring a high return are fraudulent.  Many are perfectly legitimate.  Whether you should invest in them requires you to understand the amount of risk you will be accepting.

A high-yield investment

Here’s an example of an investment touting high yields, which appears to be legitimate.  It was brought to my attention by a reader, who asked my opinion about it.

The investment is in pre-vetted real estate loans [that] earn you 9-12% annual yield.

In this low interest rate environment, returns this high would be very tempting.  To put them in perspective, on November 2, 2018, the return on a 5-year Treasury bond was only 3.04%.

Why settle for that puny return when you could earn so much more by investing in pre-vetted real estate projects?

Understanding risk

When you purchase a bond issued by the U.S. Treasury, or a Certificate of Deposit insured by the Federal Deposit Insurance Corporation, the full faith and credit of U.S. Government stands behind the obligation to repay you, with interest.

Bonds issued by others are not guaranteed by the U.S. Government.  There’s a higher risk of not getting paid, so the issuer rewards those willing to take the increased risk, with higher returns.

The webpage of the real estate investment (called “FundThatFlip”), states:

Earn 9-12% Returns

To-date, we’ve paid investors millions in interest payments and returned principal, all with $0 losses. On average, investors have earned an annualized return over 10.75% with principal repayment in under 10 months.

That makes it appear the risk may not be very great.

However, the Confidential Private Placement Memorandum conveys a different picture.  The section on “Risk Factors” starts on p. 22.  The first sentence is instructive:  Investing in the Notes involves a high degree of risk. (My bold).

Here’s one of many risks detailed in the Memorandum:

The Site and other crowdfunding portals are literally inventing the business model as we go, trying to build successful businesses by connecting investors with real estate entrepreneurs as permitted by the JOBS Act. However, the Parent Company has no model to follow and, moreover, no proof that a successful model can be built. If the Parent Company and the Site are unsuccessful, the Company's operations and future viability will be significantly adversely affected.

Here’s another one:

The Parent Company has incurred net losses in the past and expects to incur net losses in the future. Its failure to become profitable could impair the operations of its Site by limiting its access to working capital to operate the Site. The Parent Company has not, to date, been profitable, and it may not become profitable. (My bold).

The formidable list of risk factors runs for 18 pages!

Before deciding to invest in this offering, or in any other investment, remember the promise of higher returns than what you can earn from a Treasury Bond, is not a free lunch.  You are assuming additional risk.

Before deciding whether the investment is suitable for you, read the Prospectus or Offering Memorandum and pay particular attention to the section entitled “Risk Factors.”

Doing so will permit you to make an informed, intelligent decision.

Resource of the week

The article does an excellent job of discussing the biggest risks in bonds.