It would be nice to think that you could receive desirable investment returns like clockwork. Just make the right investment, with the right advisor, and you could see regular returns on your investment.
Unfortunately, investing doesn’t work like that. In fact, orderly and consistent investment returns are a sign of a Ponzi scheme.
What is a Ponzi Scheme?
Ponzi schemes are named after an Italian immigrant to the United States and Canada. Charles Ponzi was con man who made money by getting people to invest with him, and promising regular (and impressive) returns. Up to Ponzi, there hadn’t been a con man who was so successful and so widespread.
Because his impact was so widespread, similar schemes carry his name. Here is how the typical Ponzi scheme works:
- The fraudster claims that s/he can get you in on a “special” investing opportunity.
- The opportunity looks fairly legit on the surface, and the fraudster might even have some qualifications (real or made up) that seem to indicate you are working with someone who knows what s/he is doing.
- You are promised an impressive and regular rate of return. Recently, some fraudsters are toning down the promises, so that they seem more believable. Rather than being promised double in six months, you might be promised access to an “exclusive” fund that returns 10% to 12% a year without losses.
- You pay the money to the schemer. The schemer collects money from others as well.
- Money taken from other schemers is used to produce the “returns.” You might receive a pay out of dividends, or, if you plan to leave the money in the fund, you will receive doctored statements “proving” the high rate of return.
- As long as “investors” don’t all try to claim all of their money at once, the scheme can go on for a long period of time.
- Once more people start withdrawing, though, the demand for the assets soon exposes the fact that there isn’t any real investing going on or, if there is some investing, that the returns have been doctored.
One of the most famous Ponzi schemes was that perpetrated by Bernie Madoff. That scheme lasted for several years, since he had a reputation for being an investment genius. There have also been other Ponzi schemes in Canada, the most high profile being orchestrated by Earl Jones and Gary Sorenson.
Why Ponzi Schemes are a House of Cards
Say someone promised a 25% return and they gave the advisor $100,000. When the time comes to pay, the early investors would get that $25,000, but it wasn’t from some great investment decisions, it was simply from the newer investors since then. If one new investor also put in $100,000, that could possibly pay two earlier investors their return and the advisor could pocket the remaining $50,000.
This can go one for some time, especially if the investors want to reinvest their money. Going back to the original investor that gave $100,000. What if he wanted to reinvest the $25,000? This is even easier for the advisor, he can simply print a statement showing a balance of $125,000 for the investor and in reality, there may be none of that money left.
Another way to prolong this fraud is to “guarantee” a higher rate of return when locking in for a longer period of time. Instead of 25%, maybe the advisor would offer a 35% annual return if the money is left in for 10 years.
So why do these investment schemes fall apart now and end up in the media? Two things happened during the recession with the majority of investors, not just those caught up in a ponzi scheme. First, there where no new investors and secondly, current investors wanted their money out due to the fear of the market. When this happened the bottom fell out on these scams, there was no more money to pass up to the previous investor. This lead to most of these scam artists grabbing whatever money was left and going into hiding.
Is It Too Good to be True?
Watch out for investment “opportunities” that seem too good to be true. In reality, these schemes are not to be trusted. Anyone who offers a “sure thing” is probably trying to dupe you. The only way for you to receive a guaranteed rate of return is through low-interest products at insured financial institutions. Investments like GICs offer a set rate of return, but it’s not going to be very much.
If someone promises guaranteed returns in stocks, or in some special setup, watch out. True investments with the potential for high gains come with the potential for losses.
Also, be wary of “exclusive opportunities” that play on your affiliation with a particular group. A good investment is almost always open to everyone. Don’t be pressured into investing in something you aren’t sure of, and stay away from “sure things.”
I hope this will serve as a reminder to check out your financial advisor, know what it is that your advisor is investing in, and question returns that seem too good to be true. The best way to know your advisor will put your interests first is to choose a fee-only financial planner. Better yet, drop the advisors completely and invest in index funds by yourself.