News about the $65 billion Ponzi scheme perpetrated by former NASDAQ chairman Bernard Madoff has set off alarms in people’s heads about investment fraud. While Ponzi schemes have been around for nearly a century, people continue to fall prey to the false promises of their promoters.
Ponzi schemes are an old scam named after Charles Ponzi, a swindler from the early 1900s who conned $10 million from investors by promising 40% returns on postage stamps and international mail coupons. The Ponzi scheme, also known as a pyramid scam, works on the “rob Peter to pay Paul†principle. The formula is simple: Money from new investors is used to provide a return to initial investors.
However, the scheme collapses when money owed to previous investors is greater than the money that can be raised by new investors – as was the case with the Madoff fiasco. Once the market declined, investors needed their money and started to withdraw. The whole thing collapsed like a house of cards.
“The problem is that people want above-market level returns and below-level risks at the same time. And those are two incongruent characteristics of the market,†says Ivory L. Johnson, director of financial planning at Scarborough Capital Management in Annapolis, Maryland. “Madoff got a 10% return on his investments year in after year out with no fluctuations. That is very attractive to people, but it is not realistic.â€
Two things are at work: fear and greed, says Fred Joseph, Colorado Securities Commissioner and president of the North American Securities Administrators Association (NASAA), headquartered in Washington, D.C. People fear that they will outlive their savings or they greedily want something that promises to pay out a lot of money, he explains. “They are searching for alternative investments to current stock market returns or bank interest rates.â€
Ponzi schemes aren’t the only investment frauds, but they do top the list of scam artists taking return-hungry investors to the cleaners, reports the NASAA. A close second is investment fraud targeting seniors. Other schemes include unregistered securities, promissory notes, offshore investing, and charitable gift annuities. Sometimes, there’s no product involved at all; only money exchanges hands. But Ponzis or investment scams, Joseph says, may be tied to a product such as real estate, generic drugs, jewelry, and even gold mines.
To make sure you don’t part with your money under fraudulent ploys, here are a few red flags to be aware of:
High Returns: Scammers will promise guaranteed returns higher than the current market. It used to be a 50% return. But in the current market, con artists are now promising a 10% to 15% return, says Joseph.
Low or No Risk: Every investment has risk. Generally speaking, the higher the yield, the greater the risk. Johnson warns it is not possible to get constant returns year after year on any investment. Some years you make money, and some years you lose money.
Urgency: Don’t be swayed by comments that you have to act now to make sure you can get in on the deal or that this is a once-in-a-lifetime opportunity, Johnson also cautions.
Limited Documentation: Fraudsters rely on the fact that many people simply don’t bother to investigate or ask for detailed information. Madoff was able to get away with his scheme because he didn’t have an independent auditor, Johnson says. Reports should be generated by a reputable outside firm.
Secrecy: Beware if you are sworn to secrecy about the investment. Joseph says con artists often paint securities regulators as the bad guys trying to keep investors from capitalizing on a good thing.
Always check to see if the investment is registered with the U.S. Securities & Exchange Commission or local Securities Division. Make sure the person selling or managing the investment is licensed with your state securities regulator. Also check with the Financial Industry Regulatory Authority. “Don’t give someone all of your money based purely on a sales pitch,†Johnson says.
Joseph adds that unfortunately “people want to believe that everything is going to work out, that they will get their money back, and that they haven’t been conned. They want to believe in the tooth fairy.â€