5 Ways to Spot a Ponzi Scheme & Protect Yourself Against It
Saturday, October 31, 2015, 6:00 AM | Leave Comment
In the early 1920’s, an ambitious Italian immigrant was taking over the investment world from his modest office in Boston. He was investing other people’s money and earning returns no one had ever thought possible.
The promise was simple – cash today for a 50% assured return in 45 days or a 100% return in 90 days. You could double your money in a little over three months and it was all assured by this intelligent, aspiring young man.
His trick, he explained, was to buy up postal reply coupons in far off, foreign countries and redeem them in the United States, earning profits in the most assured way in finance – arbitrage.
If all this sounds amazing and makes you want to travel in time back to the 1920’s or go out looking for someone this brilliant, you may want to reconsider…
This man was Charles Ponzi, and his scheme was so brutally devious that there is a form of fraud now named after him: The Ponzi Scheme.
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How Does It Work?
A Ponzi Scheme functions through a practice that can be described as, “Robbing Peter to pay Paul.” Basically, money from a pool of investors is shown to have extraordinary returns.
Hearing about the returns, more investors rush to invest in the fund. The investor doesn’t really have a gift for stock picking – instead he’s just paying off some of the investors with the money from others.
Everyone seems to be enjoying great returns so they just put cash back in. As the trust builds and word gets around, the size of the fund gets too big to handle and the fraudster simply leaves town with all of it.
Ponzi was charged with 86 counts of mail fraud and spent his life in prison, but his fraud model lives on is still alive and well, thanks to some sophisticated crooks seeking to get rich by robbing average investors.
The most recent example was Bernie Madoff, a man who would have made Charles Ponzi proud.
Though today’s investors may be a bit savvier than those from a century ago, people are still defrauded very day in similar schemes.
So, it’s worth taking the time to make sure you know how to spot a Ponzi scheme and defend yourself against it.
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Unbelievable Returns
If you know anything about the financial industry, you’ll know that no one can guarantee you great results. In fact, even guarantee mediocre returns can’t be guaranteed.
While someone can point to data about their past successes as an indication of their skill or ability to pick good investments, no one really knows what the future holds.
So, if you’re ever promised tremendous returns, with minimal risk, your alarm bells should start to sound. Don’t let the dollar signs in your eyes blind you from the fact that if it seems too good to be true, it probably is.
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Vague Business Model
It’s an old Wall Street adage that still holds true – never invest in something you don’t fully understand.
If you look at a business or investing model and it isn’t entirely clear or the details get glossed over, move on.
Use your common sense and trust your instinct, even if you have the most respected professionals auditing firm statements.
Always remember that even Enron had its financial statements audited. Stay away from anything that seems overly complicated or much too vague.
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Foreign Investment Products (with little information)
Hiding information becomes simple when you shore up funds in a foreign country that doesn’t have very good infrastructure or information transparency. This is a combination of all the points above.
If you find someone making wild claims about an opportunity in a country far away that you know little about, your best bet is to either study it more closely or simply walk away.
When it comes to your hard-earned money, it’s always better to be safe than sorry and to stick to domestic investment opportunities for the long term.
It should be a red flag if you find that an investment fund has been unable to gather funds in more developed and open countries and has a major interest in a locked down economy in an unstable part of the world.
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Salesmen Get Massive Bonuses
Keep a close eye on how much the manager is paying himself and also paying his sales staff. If the bonuses sound high, they most probably are unsustainable.
Lack of integrity often originates from greed and there is no better way to tap greed than to offer unreasonable bonuses. Stay away.
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Investments are Risk-free
While there are some risk-free investments out there, it’s important to remember that they usually come in fairly unexciting forms.
They could be government debt that earns pennies on the dollar or an arbitrage scheme that returns half the market returns of your local index.
Always use your local bank interest rates as a rough measure of what sort of investment returns you can expect.
If the returns are way over the retail bank rate offered on your deposit, undoubtedly there is an element of risk. If someone offers you something like a 24% guaranteed return, however, you should run for the hills.
Returns like that are impossible unless the manager is taking extraordinary risk or lying to you.
You might be wondering how it is that so many people are still taken in by such a scheme, but the fact is that few can resist a “get rich quick” promise from a charismatic person who presents themselves as a trustworthy expert.
Keep an eye out for these warning signs and always keep in mind that smart investing is not the way to get rich quick.
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Andrew May is a Chicago hedge fund attorney who specializes in finance and commercial law. He’s worked with a diverse range of clients ranging from individual investors to Fortune 500 firms. Andrew also enjoys sharing his expertise as a guest blogger on a variety of investing and business blogs. You can follow Andrew in Twitter @maylawpc.
