The risks of high-yield investment programs (HYIPs)

Desperate times call for desperate measures. When investors are desperate for income yield, that desperation can lead to disastrous investment decisions. Keep in mind that investments are sometimes like the fable of the tortoise and the hare: Things with the highest apparent performance often don't have the staying power investors need.

One example is high-yield investments. High-yield investment programs (HYIPs) come in many forms. They might be exotic packages of high-interest foreign bonds. Or might be what are optimistically called high-yield securities these days, but which were once more tellingly known as "junk bonds." Also, high yields are often the come-on for investment scams that ultimately fail not only to provide the promised income, but which also fail to return all of the investor's principal.

5 signs of trouble with high-yield investment programs

When should the caution bells start ringing? You should start asking some hard questions when any or all of the following are true:

1. The yield is out of proportion with generally available alternatives

Markets are reasonably efficient. If an investment is offering a significantly higher yield than other alternatives, it either means the investment carries significantly higher risk, or the promised yield is fictitious.

2. Limited liquidity or trading

If there is not an open and active market for an investment, you should be especially cautious. The absence of a viable market for an investment means there is no general corroboration of the price being represented. The cost of arranging a sale on the back end might cost you more than any extra yield you earned.

3. No independent custody

Beware of investments you can't hold in an ordinary bank or brokerage account. That means there is no independent institution to verify pricing, or even the security's existence.

4. There's an aura of secrecy

People get sucked into frauds by the illusion they are getting an inside deal. Be cynical about any hush-hush arrangements - when investors have a legitimately valuable opportunity, usually the last thing they want to do is keep it a secret.

5. A sense of urgency

Another sign of a scam is when you are pressured to buy in on a tight deadline. Those deadlines are often created as a means of preventing people from thinking things through.

Risks of high-yield investments

Not all high-yield investments are outright scams, but some may simply be bad investments. Here are some of the things that can go wrong:

1. The numbers you are shown might be past returns, not current yields

Be wary of past returns on yield-oriented securities in a low interest rate environment. Falling interest rates create price appreciation in yield-bearing securities, but once rates have fallen those price gains are unlikely to be repeated and the current yield is now much lower.

2. The high yield might be a sign of default risk

Credit risk can undermine an income portfolio. A high interest rate won't help you if the bond issuer defaults on interest or principal payments.

3. A high yield based on foreign securities may be offset by currency changes

Yields can be very high on securities from countries with high inflation rates, but often that inflation will cause the local currency to decline at a rate that will offset any yield advantage.

4. The investment might be fictitious

From Charles Ponzi to Bernie Madoff, pyramid schemes have centered around promised returns that are just too good to be true. Remember, these schemes can suck you into investing more by actually paying some early returns. Don't let some initial success fool you into turning a small mistake into a bigger one. If you watch out for the five warning signs listed earlier, you have a good chance of recognizing the next Ponzi or Madoff.

Low risk investment alternatives to high-yield investment programs

In a sense, many HYIPs are fool's gold. Whatever advantage they offer in yield is offset by the risk of principal losses, and in the case of pyramid schemes and other outright scams, even the yield might be illusory.

When measured against the possibility of losing money in a HYIP, even low bank rates start to look more attractive. To make the most of available bank rates, look for long term CD rates that come with relatively mild early withdrawal penalties. That way you can benefit from the higher yields on longer-term CDs but still have an affordable escape route should bank rates rise. Also, be sure to compare CD rates among banks to be sure of getting a competitive rate.

Then, the next time you hear of an emerging market collapse or an investment scam gone sour, you will appreciate that sometimes slow and steady really does win the race.

Comment: What do you think of high-yield investment programs?

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