5 red flags to spot a Ponzi scheme
A Ponzi scheme is a fraudulent investment scheme where a company pays returns to its old investors' using capital injected by new investors. To keep up with the scam, more and more new investors are needed to continue paying off older investors till the pyramid becomes unsustainable and eventually collapses.
The Ponzi scheme is named after Charles Ponzi who became infamous for running such an operation in Boston in the 1920s.
Ponzi schemes usually target individuals who have limited investing knowledge. Losses can extend into the billions; the estimated size of fraud of Bernie Madoff's investment scandal is $64.8 billion. In Singapore, it was reported in the news that a family lost close to a million dollars investing in various Ponzi schemes.
So to avoid being a victim yourself, let's run through five red flags to spot a Ponzi scheme before it's too late.
1. Extraordinarily high "guaranteed" returns
Ponzi schemes usually offer abnormally high "guaranteed" returns of more than 20 per cent per annum. The attractive returns are used to lure investors to invest in their products. However, there is no such thing as guaranteed returns in this world (even the money in your savings account can disappear if the bank goes bust!) because there is always some degree of risk to every investment.
If you think about it, if a company is able to promise investors 20 per cent returns per annum, this means that they have to generate returns higher than 20 per cent in order for them to turn a profit. And if this company is able to generate annual returns above 20 per cent consistently, the owner of the company should already be one of the richest men on the Forbes list. For context, Warren Buffett's annual return over the last 51 years (1965-2016) is 20.8 per cent and he's arguably the world's greatest investor. So always be sceptical when schemes offer you abnormally high and consistent "guaranteed" returns.
2. Vague business model
Whenever I see a scheme that guarantees high returns, I always love to ask them just how they are able to generate these returns if I were to invest with them. The answer I usually get is that the investment process is confidential and they cannot tell me! So then how can anyone invest in a company if they don't understand how the company actually makes its money?
Even if they do explain how they make the money, the business model is usually overly complex and hard for a normal individual to understand. The point is: don't invest in a company where you don't understand how they are going to generate returns for you.
3. Investment products are usually foreign
Most Ponzi schemes' investment products are usually based in places far away from where they raise funds. Investors who invest in such schemes are usually normal folks who do not have the time or money to fly overseas to conduct their due diligence on the products the company is selling.
Think about it: If an overseas investment is really that good, shouldn't it have been bought up by local investors before it even reaches your country? The main reason why many schemes raise funds in another country is usually because they are unable to sell successfully in their home country.
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4. Sales personnel have attractive commissions
Sales personnel in Ponzi schemes are usually highly motivated to promote the scheme because their commissions are very lucrative. I remember a story where a friend of mine was approach by one sales personnel who wanted to promote a foreign property investment to his network of investors. The sales personnel offered my friend a 20 per cent commission for the amount of funds raised and still guaranteed investors a 20 per cent annual return. What shocked my friend was that the sales personnel also received a 15 per cent commission from the deal!
To put it in numbers, if you invested $100,000 with them, $35,000 is immediately paid as commission. Hence, the firm is only left with $65,000 to invest and generate 20 per cent returns on the $100,000 invested; the actual required rate of return is 30 per cent! And that's just for the investors - they need to generate more than that to also make a profit for themselves. Therefore, always find out what the sales personnel commission structure is like. If it is too high, it is usually unsustainable.
5. They are advertised as "risk-free"
I remembered visiting an investment talk that sold multiple investment products ranging from property to commodities. All their products had "guaranteed" returns anywhere from 24 per cent to 100 per cent per annum. I wondered how the company was able to sell so many different products and was yet able to generate such high and consistent returns for investors.
I am generally a sceptical person when things are too good to be true. Since they had only been talking ad infinitum about how great their investments were, I decided to ask them instead what the risks for the investments were.
The answer they gave me was that there was no risk! They carried on: "All the investments are risk-free and are guaranteed to make money for you."
When you hear stuff like that, you run. All investments come with a degree of risk, it all depends on how you manage it. Since the sales personnel didn't even know what the risks were, what more do average folks know? There is no such thing as a risk-free investment. Simply avoid companies that tell you that their investment products have no risk.
The fifth perspective
While it's easy to say the fault squarely lies on the perpetrators behind a Ponzi scheme, you only have yourself to blame if you invest in one. Instead, seek to increase your investment knowledge to prevent yourself for ever falling for such scams. Be sceptical of investments that are too good to be true and always do your due diligence before investing in any investment products.
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