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 300% per annum (or even more ridiculous — per month!). 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 300% returns per annum, this means that they have to generate returns higher than 300% in order for them to turn a profit. And if this company is able to generate annual returns above 300% consistently, the owner of the company should already be one of the richest men on the Forbes list. So always be skeptical 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. 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% commission for the amount of funds raised and still guaranteed investors a 20% annual return. What shocked my friend was that the sales personnel also received a 15% 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% returns on the $100,000 invested; the actual required rate of return is 30%! 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.
4. It relies on new members to sustain the scheme
As mentioned earlier, Ponzi schemes rely a lot on new members to sustain the model. That is the only way they can guarantee the consistent returns we mentioned above. The higher the rate of growth of new members, the higher the likelihood of the Ponzi collapsing. Agreed, there are other business models out there that rely on new investors to grow but they are tightly regulated and the funds are tied to specific investments. Cooperatives for example are a bit like that which is why they are recognized by law and managed by a recognized governing board. Ponzis bear no such hallmarks.
5. Owners and creators of the scheme hardly advertise
They rely on word of mouth to spread the “good news.” Word of mouth is perhaps the most common selling points for Ponzi. They hardly advertise because, like we opined, they cannot clearly explain what they are doing with their money. Most investment schemes such as mutual funds or pension funds, often advertise on TV, radio or in the pages of the newspaper and will also offer a prospectus detailing what they intend to invest your money in and what sort of returns to expect. They also clearly spell out the risk involved and the recourse in case the business goes bad. Ponzi has no such structure; so they rely on word of mouth and high returns to draw innocent investors in.
These schemes are easy to spot and if you do a little digging around, you’ll easily tell which schemes will collapse and when. Most Ponzi schemes don’t last longer than 2 years. The average age of a Ponzi scheme is 6 months to a year.
So don’t be played. Look before you leap. The secret to wealth creation is not in making money, but keeping it.
If you want to know why BiTDAX is not a Ponzi scheme, check out this article on
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