Named after the 1920s fraudster, Charles Ponzi – who promised investors in New England a 40% return on their investments in 90 days, compared with 5% interest earned in savings accounts – the Ponzi scheme is the oldest and most common type of investment fraud.
In its simplest form, a Ponzi scheme is essentially a pyramid scheme that operates on the basis of ‘robbing Peter to pay Paul’. The promoter (or the fraudster setting up the Ponzi scheme) pays the initial investors enormous returns using the investments of later investors rather than from business profits. Ponzi schemes generally have no viable business model and very rarely generate any legitimate profits of their own. Their survival is dependent on a constant flow of new investor money which, if not found, will result in the ultimate collapse of the entire swindle.
A Ponzi scheme can take any shape or form – depending on the inventive imagination of the promoter – and can be run by anyone with an inclination for chicanery. In most Ponzi schemes, the promoter and early investors will make the most money and live lavish lifestyles, whereas the later investors will inevitably lose everything.
In the early stages of a Ponzi scheme’s existence, the promoter pays out high returns ‘as promised’ to build trust with the early investors and encourage new investors. Once the supply of new investors inevitably dries up and the promoter is unable to pay out returns, investors become suspicious and distrustful.
Sadly, investors are often slow to admit that they’ve fallen victim to a Ponzi scheme. Besides the understandable anguish of being perceived as both foolish and greedy, many fear that public exposure will create a crisis of confidence that could create a run on the promoter and make matters worse. Clinging to even the smallest fragment of hope, investors have been known to go to enormous lengths to protect the promoter in the hopes that they can recover some money.
When it comes to investing, it is advisable to exercise great caution and look out for any of the following warning signs:
1. Abnormally high investment returns
The most obvious sign of any investment skulduggery is the promise of an abnormally high investment return. While Ponzi schemes may take a variety of forms, they all follow the same intrinsic theme: investors are promised they will make a much higher return than can be achieved through any conventional investment opportunity. When analysing investment opportunities, remember the adage: if it’s too good to be true, it probably is.
2. Guaranteed returns
The words ‘guaranteed returns’ are designed to trigger both deep-seated investor greed and the willing belief that this is a ‘sure-fire thing’. However, when it comes to investing, no return is ever guaranteed and even the most modest investment carries some risk. Greed is your greatest enemy when investing. Be highly suspicious of anyone who offers you a guaranteed return on your investment.
3. Consistently high performance
By their very nature, the investment markets rise and fall over time, and your returns in any reputable investment will reflect these market fluctuations. Be sceptical of any investment that promises consistently positive returns regardless of overall market conditions.
4. Vague business model
If you don’t understand the business model after a five-minute explanation, stay away. The investment’s business model should be easy to understand and, as an investor, one should be clear where and how returns are generated. Fraudsters are notorious for using complicated verbal constructs such as ‘hedge future trading’, ‘high yield investment’ and ‘offshore investment program’ to intimidate would-be investors. These are smoke-and-mirror tactics used to confuse and bully investors. As Warren Buffett is famous for saying: “Never invest in a business you can’t understand.”
5. The need for more investors
The survival of any Ponzi scheme is dependent on its ability to continually attract new investors. Without an ongoing stream of new investors, the fraudster is unable to pay the previous investors, and the whole scheme will unravel. If you are pressured into finding new investors or offered rewards for introducing new investors, alarm bells should be reverberating.
6. Pressure to reinvest
Ponzi schemes will collapse without regular income or if too many investors withdraw their funds. To remain afloat, the promoter will offer investors higher returns if they don’t cash out or if they reinvest their money. While on paper investors believe their investments are gaining incomparable ground, the truth is that most Ponzi schemes don’t make any investments on behalf of their investors at all. If you’re pressured or rewarded for reinvesting, be alarmed.
7. The pressure to act now
Ponzi fraudsters are also notorious for creating a false sense of urgency by leading the investor to believe the deal is only valid for a limited time. The investment opportunity is often shrouded in secrecy, and the investor is pressured to ‘act now’ while the ‘once-in-a-lifetime’ window of opportunity stands obscurely and suspiciously ajar. The pressure to invest within a certain period is foreign to sound investing principles and should be considered a red flag.
8. Credibility through association
A Ponzi scheme promoter generally creates an air of exclusivity by luring would-be investors into his inner circle of family and friends. By proximity to those who are close to the fraudster, the investor’s fears are allayed – after all, foxes never prey near their dens and thieves don’t rob from their own homes. This is a powerful psychological tactic used by fraudsters to build credibility through association with reputable people who are known to them. Remember, Bernie Madoff managed to deceive those nearest and dearest to him, including his sons.
As enticing as the notion of making money can be, the most effective way of creating sustainable wealth is by investing for the long term through reputable and credible institutions who have proven their mettle.